Using Covered Call Options to Increase the Value of Your Stock

If you had a $1000.00 more today than you did yesterday, is your net worth +$1000.00 or does it depend where that cash came from (this is not one of my trick questions). What if you earned it at your job? Investment income? Found it on the street? Gift from grandma? Got lucky at the casino? The way I see it, a thousand dollars is a thousand dollars no matter the origination of that cash. It can be withdrawn from the bank and off to the mall we go.

The same can be said of the monetary growth of our portfolio when selling covered call options. Why just close our eyes to the option returns (great as they are) and not consider share appreciation generated through savvy execution of exit strategies. There are times that we can increase the value of our stock by taking advantage of the difference in time value from month to month. I am speaking, specifically, on or around expiration Friday when your share value is higher than the strike price. We know that if no action is taken, our shares will be assigned and sold at the strike price. For purposes of realistically evaluating the worth of our portfolio, the shares are worth the strike price (our obligation to sell at that price) times the number of shares. Any share value above the strike price is NOT ours.

If the stock still meets all system criteria (including a check of the earnings report), the next step is to do our calculations (ESOC to the rescue). If we opt to execute a rolling out strategy, we buy back the option and sell the next month same-strike call. Our profit is the difference between the two premiums divided by our cost basis which is (100 x the strike price) per contract. This strategy is relatively simple to understand and a big money-maker for Blue Collar Investors (see pages 122-123 of Cashing in on Covered Calls).

A strategy that will elevate our returns even higher is when we roll out and up. This is a more bullish maneuver than simply rolling out and utilized when market tone and stock technicals are positive. We also execute this exit strategy on or near expiration Friday when the stock value is above the previously sold strike price. In this case, there is a small gain or more frequently a small loss in option premium but this is only one aspect of the “deal”. By removing the restriction of the first strike sold and elevating that ceiling to a higher strike, we are now enhancing the value of our stock to either the current market value or the new strike sold depending on which is lower. This increase in equity value must be calculated into our portfolio worth, just as the $1000 in our bank account that came from good ole granny. Furthermore, if the new strike is higher than the share market value, there may be some upside potential to sweeten the deal.

Let’s clarify these comments with a real-life example taken from the option chain of SNDA as of the market close on July 2, 2009. Although there are two weeks remaining until expiration Friday, we will treat this as an expiration Friday exit strategy. It is the concepts and ability to apply these ideas in various situations that is of utmost importance.

• Previously purchased 100 x SNDA and sold the July $50 calls
• Current market value is $53.15
• Buy-to-close the July $50 calls = $4.60
• Sell-to-open the August $55 calls = $3.80
• Option loss (4.60 – 3.80) = – 0.80

At this point many covered call writers would be heading for the hills! Why lose $80 per contract? Should we be examining the deal or our heads? Let’s evaluate this deal like a true Blue Collar Investor and factor in ALL facets of this strategy:

By removing the $50 ceiling on SNDA, we are allowing it to grow in value to the current market value of $53.15, thereby gaining $3.15 per share or $315 per contract….grandma just handed us all this cash-we must count it! In addition to that, the ceiling is now @ $55 and our stock can grow in value another $1.85 per share without restiction. Let’s calculate these new, improved numbers:

Loss on option premiums (from above) = -0 .80 

Share appreciaition – option loss = 315 – .80 = $235/contract

235/5000 = 4.7% return

Upside potential = 185/5000 = 3.4%

POSSIBLE total profit on this deal = 8.1% (4.7% + 3.4%).

Once again, this is a bullish strategy to be used when market conditions and stock technicals warrant a positive expectation of share appreciation.

Conclusion:

Many covered call writers buy a stock, sell the option, get down on their knees, clasp their hands and pray for positive results. Blue Collar Investors, on the other hand, manage their positions with educated, non-emotional decisions, factoring in every bit of information even facts that others can’t see. For more examples of this strategy, see pages 102-109 of Exit Strategies for Covered Call Writing.

Last Weeks Economic News:

After several months of predominently positive economic news, expectations of a quick recoevry were lessened by some negative reports. Job losses caused unemployment to approach 10%, a new 26 year low. Construction spending and consumer confidence declined. On a positive note, the construction industry reported an increase in factory orders and sentiment. For the week, the S&P 500 fell 2.5% for a year-to-date return of 0.6%. Viewing the chart of this major index, we see it to be in a period of consolidation as investors hold their collective breath to see which direction it will turn. A spike up on high volume will be an encourasging sign. The chart:

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