JNJ - an interesting variation of Double Diagonals

I have an interesting trade. It is a variation of a double diagonal.

Normally, for a double diagonal, you buy 2 deep ITM LEAPs for call and put. Then you sell, every month, short calls and short puts to recover the extrinsic value when you bought the LEAPS.

I did a trade on March 22nd on WMT.. I recovered all the extrinsic by May and am collecting income every month currently. I expect I will end the trade with around 15-18% return on an annual basis.

I decided to make an improvement on the trade for JNJ. This company has an annual dividends of 3.4%. If I strictly do a DD, I will not benefit from the dividend payout.

So instead of buying a LEAP call, I bought just the stock and a LEAP put. By buying the stock, I did not incur any extrinsic value as it was not an option. The mechanics of trading is the same. I will sell short call and short puts month to month for income. I expect this trade to be risk free in about 3 months.

Fundamentals.

JNJ is one of those big caps stock that is selling at a bargain now. The recovery is uncertain. But if it does recover, the stock should see nice gains from its current level. If it does not recover, this strategy is going to protect the stock from any downside because of the long term deep ITM LEAP put. As the stock declines, the put will gain in value roughly equal to the stock because it is deep ITM.

Like many other value stocks, it has gone nowhere. The stock today is about the same price as it was 11 years ago but the company has grown substantially. If you measure growth by book value, JNJ is 70% cheaper today than it was in 1999. Back then, the stock traded 10 times book value and today it trades 3 times book value.

Johnson & Johnson is a no-debt business. (With $18 billion in cash, it has more cash than debt.) It has an incredible collection of brands, which should insulate it, somewhat, from economic downturns.

At some point, these stocks will break up. It is almost impossible to predict the time. It may go down if there is another market crisis but if the recovery is intact, then the stock is almost certain to break up.

JNJ dipped below 4 X book value in early 1994, the shares soared 150% within 2 years.

JNJ is trading at 13 X PE now. J&J fell to 11.9 times earnings in March 1980. The stock doubled in less than three years. In June '84, it traded down to 10.9 times earnings. The stock nearly tripled over the next three years. Its next big valuation low was April 1994, at a P/E of 13.8. The stock tripled in three years.

The stock is cheap today. Most of the risks are priced into the stock.

But I am not going to be presumptuous. The trade below will cater for the downside but will ride on the upside.

Trade:

Buy 1000 stock at 63.15
BTO Jan 2012 P for 19.7. This gives an extrinsic value of 2.85
STO Nov 60 SP for .29
STO Nov 65 SC for .48.

Manage the trade on a month to month basis by selling front months call and puts.

Never all the SC or SP to go ITM. If it is close to ITM, you can always roll it up to the next month. You have 14 months to roll the shorts - plenty of time. If the shorts are ITM, there is also a risk of getting assigned and it will mess up the whole trade.

If the stock suddenly gaps up or down ( unlikely ), the trade will make money because of volatility spike. This is in theory a strangle trade.

At some point, if the stock spikes up on a clear up-trend, I may close the LP and decide to play a bullish direction.

If it goes down, the stock is always protected by the put for 14 months.

The immediate objective is to sell enough shorts to pay back the extrinsic value of 2.85 for the put. Once it is paid, the trade is a risk-free trade. It becomes a pure income trade with minimum risk if you manage it every month.

From the options premium, it will take about 3 months for the trade to repay the extrinsic.

A target of about 15% is achievable. Together with the 3.4% dividend, the objective is make a return of 20% annual. If the stock breaks up and we adjust the trade bullishly, we can make 50-100%. Downside risk is almost zero.

This trade can be applicable to any solid big caps with good dividends like COP, WMT, MSFT, etc. Once I have proven successful, I will probably add 1-2 two more similar trades to my portfolio.