One of our members recently asked us a question regarding generating monthly income while mitigating risk, and so we thought it might prove helpful to share some of our thoughts, particularly given the recent run up in equity prices. The member had 5,000 shares of company stock and was concerned the stock would decline if the overall market fell. At the same time, he didn’t want to sell his stock in case the stock managed to creep higher. While he thought some upside was possible, he felt it was limited. For every situation, an optimal strategy exists and for this situation, the Covered Call fit the bill!
While Covered Calls may be applied in myriad ways, the strategy that best met all the stated objectives was the at-the-money Covered Call. The at-the-money Covered Call simply comprises opening short call options at a strike price close to the stock price. In general, for every 100 shares owned, 1 short call contract is sold. So, for a 5,000 share position, 50 short call contracts may be entered. The stock in question was Cypress Semiconductor, trading on Monday’s close at $26.86. The nearest strike short calls were the strike 27 short calls, which in May offered $0.60 of premium. Knowing the premium and the strike means that our Cypress shareholder wouldn’t want to see the stock rise above $27 by more than the net credit amount prior to May’s expiration – otherwise it would have been more lucrative in the short-term to simply hold the stock position. Because $27.60 is so close to the existing $26.86 stock price, and with the market running up so quickly since our mid-April bottom call, a June strike 27 option offering $1.40 credit may be considered more prudent. The additional credit means additional protection if the stock were to fall. And it also means if the stock should rise higher, our member would be no worse off with the stock rising $1.40 above strike 27, hence to $28.40 by June’s expiration than simply holding the stock alone.
The result of selling $1.40 or premium on 50 contracts is a $7,000 windfall in 45 days! Not a bad return given that the 5,000 share position is worth $134,300. Just think about doing this every 45 days for a whole year, the result would be $56,000!
Now what happens most people when they first encounter this strategy is they begin a journey of self-discovery. First, the joy!! Whoohooo! Our member had been working for 8 years at Cypress and had amassed the 5,000 share position from stock options, bonus plans, employment stock purchase plans and so forth. The potential to boost income by as much as $56,000 over the course of the year was welcomed enthusiastically! But we cautioned against too much exuberance because most traders new to the strategy react favorably until….greed takes over! While most traders are happy when the stock stays flat, rises a little or falls, because in all those situations they end up in a better position with short call options than without them, most also experience the big bullish up trend and end up with short calls in-the-money at some point! When this occurs, the risk of being assigned an obligation to sell the underlying stock at the agreed upon strike price is high. Certainly by expiration, if the short call is in-the-money, assignment will automatically occur. And that’s when regret kicks in. Most traders chastise themselves for limiting their profit potential. So what can be done to alleviate the emotional roller-coaster?
Simply step back and ask some questions. For example, if I could get $1.40 every 45 days from short call premiums, what would that equate to over the course of a year? Answer: $11.20. Do I expect a $26.86 stock to rise by $11.20 this year? Perhaps. But $11.20 amounts to a 41% stock gain. Next question: Do I expect the stock to increase by 41% next year and the year after, and the year after that and forever more? Obviously not! In short, if a longer term view is taken, the benefits of shorting calls regularly is obvious! In the short-term could it be more profitable to simply hold stock? Certainly. But this is not a short-term game and those that fall victim to chasing short-term gains often suffer longer-term under-performance!
As an aside, we will consider a few other Covered Call examples below:
First, we will look at Microsoft (MSFT). Now that MSFT retracted its bid for Yahoo, the stock has found a home near the $29 level. If we were to purchase 1000 shares of MSFT and sell to open 10 short call contracts at strike $30 in June, we could take in $730 of premium. The Cost Basis in the trade would be calculated as the cost of the stock, $29.08, minus the short call premium, $0.73. Hence, the Cost Basis would be $28.35. The result of the short call at strike 30 is an obligation to sell Microsoft at $30 if the stock should rise above that level by June’s expiration. This would equate to a $1.65 per share profit in approximately 6 weeks, which amounts to an annualized gain of 46%! Note the stock simply needs to rise $0.92 for the overall position to profit $1.65! Hence, a 5.8% gain can be banked even if the stock only rises 3.2%! And if the stock were to drop lower, 2.5% downside protection is afforded by the 6 week short calls. Obviously, if the stock were to continue dropping, further short calls could be added to reduce cost basis and risk.
Next up, we’ll look at Potash (POT). Potash certainly does move around quite a bit and is not for the faint of heart! The more aggressive (or higher risk) trader may be 110% fine with simply buying some shares and expecting the shares to rise considerably. But what about a more conservative trader? The Covered Call strategy might suit their risk tolerance much better! The stock purchase would amount to an outlay of $193.89 as of the close on Monday while a June strike 195 short call offers $15 of premium. This means the net cost of entering the position is $178.89. If the stock were to rise to $195, the result would be a per share gain of $16.11, which equates to a return on risk of 9%! Again the movement in stock price required to produce a very handsome gain is minimal. In this case the stock must simply rise $1.11, less than 1% to make 9%! Beat that buy-and-hold investors! We won’t even discuss annualized gains for such a position, but suffice to say they are quite attractive!
As you already know from our Trade Alerts, we have built up more hedges and bearish positions entering May. For those of you that are stock holders, some hedging in the form of Covered Calls aligns well with the "cautious" theme!
Make it a great day!
