In a choppy, overdone, fake market, I find that buying bottom feeders who are selling calls is about the safest thing we can do.
On Sunday evening, I was talking about the use of covered calls as a long term hold strategy, and that talk brought me a couple dozen questions about “how to do them?” So I want to discuss their use.
We are going to explore the most overlooked tool that a investor can use--the covered call. This will be a long one folks because I am a real believer in using them in certain circumstance.
Writing a covered call simply means you are selling someone the right to buy your stock from you. Options are bought and sold in 100 share lots called "a contract" So if you hold 1,000 shares of something you could sell 10 contracts against it, and if you owned 200 shares of something you could sell 2 contracts. Your ONLY obligation is to hold the underlying stock past expiration day. You never have to add any money for extra expenses. Only sell a covered call that is "out of the money" In other words if you own XYZ at 50 don't sell the 45 call because it will be snatched away from you quickly! You would sell the 55, or 60-dollar call with the hopes the stock never makes it that far and you simply keep the premium and the stock.
There are thousands of people who write (sell) covered calls as a profit making tool, there are supposed "gurus" that teach how to become wealthy by using them, there are others who consider them a waste of time and yet others who don't know they exist. What the heck are they?
A covered call is a tool like any other option. It is a tool that we can use in certain circumstances to increase profits and that is why you are trading stocks...to increase profits. So, knowing they exist and using them correctly will indeed help your portfolio. Forget anything else you have ever heard about covered calls and remember this simple line... a covered call is a way to sell someone the right to buy a stock from you, a stock that you already own, for a higher price than you paid. Period. Okay so why is that such a good tool? For many reasons, let's look...
If you own a stock wouldn't it be nice to generate some income on that stock instead of just letting it "exist" in your account? Even if the stock has been performing for you, you can increase its performance with the use of the covered call. Do you have any stocks that you bought thinking they would rise but instead they have fallen and if you sold them you would take a loss?? Enter another reason for using covered calls. Actually there are a number of ways to use them, but for this installment we will explore just what the heck the mechanics of them really are.
If you don't know where to get options quotes, a good place to get them for free is at www.cboe. Now remember a covered call means that we are going to sell someone else the right to buy a stock from us that we already own. For this example, let's use Intel...symbol INTC. Suppose you have 1,000 shares of INTC in your portfolio. You paid 46 bucks a share for it and you don't really wish to sell it, but it would be nice to make "extra" money on it right? Right. So what you can do is this…sell the right to someone, to buy Intel from you at a much higher price. For instance INTC closed Monday at about 52 dollars per share.
Why not sell someone the right to buy INTC from you at 57.50 s per share in January?
If you look down the option quotes for January, with 57.50 dollars as the strike price you see they are bidding 0.60. That means that you could take in $0.60 for each share of INTC you own simply by giving someone the right to buy it from you at 57.50 per share by the 3rd Friday of January.
That isn't bad because in our example you already own 1,000 shares so you would take in $600 dollars for placing the order. So for making a phone call, you have just received 600 hundred dollars.
What's the catch?? There really isn't any catch, but there are rules. If INTC announces some fantastic news and flies to 65 per share by January…you will still have to sell it for 57.50. You would miss the huge run up. You are obligated to sell INTC for the strike price you sold the rights to. 57.50.
What happens if INTC doesn't make it to 57.50 per share?
Well, no one is going to buy it from you at 57.50 if it's trading on the open market for say...53.00 so guess what? We keep the $600 we got for selling the option and we keep our stock ... This is why they are so attractive for long-term hold stocks.
Once option expiration day passes, if the stock hasn't made it past the strike price we sold, we keep the stock, all obligations go away, and we can do it again! Not bad. One thing you may consider a "catch " is this ... Once you sell that call, or in other words the right for someone to buy your stock at a certain price, you MUST keep ownership of the actual shares, just in case you have to deliver them at some point.
So if you sell someone a call like in our example and the stock falls like a rock, you are still going to have to hold that stock. What you do at that point is this: "buy back" the calls you sold. If we sold them for 40 cents, and the stock crashes, they will soon be worth 10 cents, so you buy them back for 10 cents, cancel out the trade, and then you are free to sell the stock.
A lot of stock gurus teach how to make a killing writing covered calls, but I find most of it to be a bunch of hooey. I find they work best for adding money to a long-term portfolio, and for what I call damage control. Here is why ... The guys who set the options prices are wizards at it. When you find a ten-dollar stock that is getting 3 dollars for a call option, you can bet there is tremendous volatility involved in that stock.
Too many "gurus" say, "buy that 10-dollar stock and sell the covered call...see you'll get 3 dollars per share instantly!" That is correct, but what if the stock itself plunges to 5 bucks per share because the news that made the options so expensive turned out to be false?? You will end up with a stock you didn't want to own, and in a losing position. So you have to be very careful about buying a HIGH FLYING stock with the sole purpose of selling a call against it. Sure it will work at times, but overall it can be a losing proposition.
We find it better to write calls against stocks that we already own because we like the stock, not because we bought the stock for the rich option premiums we could get. We also like to find stocks in a sector that have been beaten bloody and sell calls against them. Why? We want to lower our risk as much as possible. If you see a sector like the metals miners, where XYZ was once a 60 dollar stock and now it’s trading at 4 bucks, selling the 5 dollar call, is pretty risk free.
Which brings me to the buy/write. Basically a buy write is nothing more than buying a stock, and immediately selling a covered call against it. Remember I like beaten down stocks, but one’s that most probably won’t “belly up.”
So take a look at RIG. This once high flyer in the oil patch is trading Tuesday at 4.59. So let’s suppose you buy 1000 shares of RIG. Okay, you’ve spent 4,590. Then you look at the options chain and you see that the January 5.00 calls are bidding 46 cents per share.
What that means is that “the market makers” will pair you up with someone willing to give you 46 cents per share, for the “right” to buy RIG from you at 5.00 between now and Jan. 20. Why would they do that? Market mechanics, and the bull/bear struggle. Someone always thinks stocks will go up, as they do down.
So, you have 1000 shares of RIG. You decide to sell the Jan. 5 call. You place the trade and instantly 460.00 dollars will show up in your account. That money is yours no matter what RIG does. Now let’s suppose RIG is NOT higher than 5 bucks in January. Let’s say it makes it to 4.91. Will someone buy your RIG for 5 bucks when it’s trading on the open market for 4.91? NOPE. The option obligation will expire and you’re 460 dollars richer AND you still own the stock.
At that point you could simply go out to say the May options chain and sell that 5 dollar call again. But, what if RIG IS over 5.00 in January? Then your stock will be “taken” from you at 5 bucks a share, even if it’s trading on the open market for 5.50 or 6, or what have you. But hey, it’s not all bad, is it?
Let’s do some math. You paid 4,590 for your RIG. You sold calls and took in 460 bucks. Well, 460 dollars back on a 4590 outlay is 10%!! Yes 10% return for what would be a 3 month hold. What’s not to like?? Better yet, this..
You paid 4.59 originally for the stock. They take it from you at 5.00 because on the open market it’s trading at 5.30. BUT, you also made the “appreciation” from where you got it ( 4.59) and where they took it (5.00) which is 41 cents per share. That’s 410 bucks, since you have 1000 shares. Add that 410 to the 460 you took in for selling the call and you’ve taken in 870 bucks on a 4,590 purchase. That my friends, is a 19% return on a 3 month hold.
Covered calls are also scalable. Instead of buying 1000 shares, you can buy 10,000 shares. Then you can sell 100 contracts of the underlying. It’s all up to you.
In a choppy, overdone, fake market, I find that buying bottom feeders who are selling calls is about the safest thing we can do. I hope you find it so.