You walk into your local stationery store and pull out a $20 bill. “Give me 20 state lottery tickets, please.” You can’t help but dream of all the riches that $20 investment will provide to you. After all, the grand prize is up to $25 million dollars. You even go so far as to compute the money left over after taxes! Some of you (and you know who you are) are formulating the manifesto you will present to your dreaded boss after the drawing (stop smiling and admit it!).
You are now the buyer of a decaying asset. When that drawing takes place, you will either be incredibly wealthy or more likely your ticket will expire worthless. Your brain tells you that the latter situation will occur, despite the fact that your heart told you to do the deal. Come Sunday morning, you are back in the stationery store, reaching for another $20 bill hoping to make up for last weeks losses.
So what does this scenario have to do with selling covered call options? I always allude to this strategy as a safe form of investing (although there is some risk in the stock). The government concurs with this opinion as we are allowed to use it in our self-directed IRA accounts. We are selling an asset that is at the mercy of time decay. Better yet, the greatest amount of time decay occurs as we near expiration Friday and we sell predominently 1-month options. Every expiration Friday, 80-90% of all options expire worthless! Would you rather be the buyer or seller of a decaying asset? When we sell covered call options we are the state collecting money for lottery tickets. We are the casino running the business of allowing gamblers to throw their hard-earned money into the slot machines (sorry Mom!). Sure the state and casinos have to “pay up” from time to time, but that is expected and inherent in a system that generates small but consistent returns over and over again. Based on this concept, I am asked at all my seminars, “why then are there option buyers?” The answer lies in the lure of the big return. The casinos and lotteries are still in business, aren’t they. We are happy with our 2-4% monthly returns, others aren’t.
Let’s create an example and look at it from our perspective and from that of the option buyer (aka the gunslinger):
The Option Seller (You and me):
1- We buy 1000 shares of company XYZ @ $48 per share for an investment of $48,000.
2- We sell 10 contracts (100 shares per contract) @ $2 for an option return of $2000.
3-We have generated a 1-month return of 4.2% (2000/48,000) or 50 % annualized.
4- If our shares are assigned (pass the $50 strike with no exit strategy invoked) we double our profits as we garner another $2000 on the sale of the stock (1000 shares going from $48 and sold @ $50). This computes to an 8.3% 1-month return. Now that’s pretty impressive but let’s examine the motivation of the option buyer (holder).
The Option Buyer (aka, the gunslinger):
1- Purchase 10 $50 Call option contracts for company XYZ @ $2 for an investment of $2000.
2- If the shares appreciate to (let’s say) $54 by expiration Friday, the option value has $4 of intrinsic value ($54 – $50) and will have at least doubled in value. Stated differently, the buyer can exercise his (her) right to buy those shares from us @$50 and turn around and sell them at market for $54, thereby generating a $4 per share profit or $4,000 for the 1000 shares. Let’s deduct the option premium of $2000, so the real profit is $2000. This represents a 100% 1-month return or 1200% annualized. Of course, there is no limit to the amount of money the buyer can make since the stock appreciation has no limitations. Now you can see why we have option buyers. They also buy the lottery tickets and play the slots.
Pros and Cons:
Okay, calling the option buyer a gunslinger may be a bit unfair. I’m a conservative investor always emphasizing risk management over profit optimization. Buying or selling naked options (not covered, without owning the underlying equity) is too risky for my comfort level. There are some advantages to buying call options and it’s only fair I mention them. First there are the obvious possibilities of generating through the roof fabulous returns that are not achievable as the seller of covered calls. Secondly, option buyers are controlling large numbers of shares at a relatively low cost. In the above example, the option seller is controlling 1000 shares at a cost of $48,000. The option buyer is controlling these shares at a cost of only $2000. Furthermore, the buyer can only lose the $2000 investment, whereas we, the sellers are risking $48,000 (that’s where our exit strategies come into play).
The advantages to the option seller far outweigh those of the buyer. We are selling a decaying asset. If the option expires worthless, we win because we still have our shares plus the option premium. If the share prices exceeds the strike price and we allow assignment, we still win because we have made a profit on the option sale and possibly additional income on the sale of the stock. No problem if the buyer of the option also generates a profit. Remember, we are the state selling lottery tickets. Money is consistently coming in month in and month out. Every so often we will have to pay out (lose out on equity appreciation) some cash to the lottery winner. This occurs when our equity appreciation goes through the roof during the contract month. Let’s say that $48 stock that we sold the $50 call option on goes to $70 by expiration Friday. We get paid $50 per share and the option buyer makes out like a bandit. Do we shed any tears? We shouldn’t because we still made a great 1-month profit and will do it over and over again, not just once in a blue moon.
The decision as to whether to be an option buyer or seller is yours to make. Are you happy with consistent monthly returns of 2-4% (in normal market conditions) or are you looking to hit that grand slam homerun? Do you want to feed the slot machines or collect the money from them at the end of the day? You worked hard for that $20 bill. Maybe you should put it back in your wallet.
The industries that will get this economy back on track, in my view, are housing, automobile, and banking/financial. The 1-year charts of these industries are by no means strong or even positive. But the fact that they are improving to a consolidating and in some areas uptrending patterns is a sign of encouragement. A strong economy will definitely drive the stock market back up but so will the perception that things are improving. It wouldn’t shock me if it took most of this year to finally feel that the economy is on the right track. It also wouldn’t surprise me if the stock market showed improvement much earlier. The charts that I have been looking at to evaluate market tone appear to be consolidating. If we are at a bottom, that bottom can remain with us for a while. We can even test previous lows. Given the improved chart patterns of these industries along with those of the S&P 500 and the VIX has motivated me back into the options game with a conservative portion of my stock portfolio. I will be extremely diligent with my monitoring for potential exit strategies because of the unpredictable market environment. Here are the industry charts I alluded to above:
Economic News of the Week:
I suggest you close your eyes as you read this section. Several negative economic reports re-enforced the continued global economic slump. The U.S. suffered through lower industrial production , decreased retail sales and reduced international demand for U.S. exports. The economic crunch along with lower energy prices continued to push consumer and wholesale prices lower for the fifth straight month. For the week, the S&P 500 fell 4.5% to 850.1 for a year-to-date return of -5.78%. You can open your eyes now.
To those of you who are selling covered calls in this market environment:
If you find a stock that has been working well for you, we’d love for you to share it with our group. You can post it by clicking on the “comments” link of this article (with or without your name) or by emailing me directly @ firstname.lastname@example.org
To those of you who have asked about my upcoming book:
Thanks for all those emails. The book is in the hands of the publisher. Because of all the charts and graphs, they tell me about 3-4 months before it will be available to the public. All those on my mailing list will get first notice of its availability. To join my mailing list use this link:
Wishing you a warmer week than we’re having here in New York,