The recent volatility we have seen in the stock market, while certainly concerning, offers some interesting potential for investors. One strategy that I have used over the years that works particularly well is covered call writing. In this week’s column, I will explain covered call writing and put selling, and also will discuss the situations in which they may make sense.
Many local investors have called me recently asking what they should do given the huge run-up we have experienced in stocks—almost 100% over the past year or so, before this latest pull-back—and given the increasing risk of problems associated with Europe (as I wrote about last week). Many local investors have large positions in stocks that they have held for many years and in which they have a low cost basis, and are looking for strategies to enhance returns.
As mentioned above, one strategy that can make a lot of sense when volatility is high is covered call writing. Option values go up dramatically when volatility is high, so this is a great time for selling options. One strategy involves selling call options against stock positions in the portfolio. As an example, let’s say an investor owns 1,000 shares of Apple, which is currently trading around $260 per share. They could sell 10 October call option contracts against this position for about $25. This transaction would result in the investor bringing in $25,000 to the portfolio, which is roughly 10% of the value of the stock position (this is an exceptionally high premium percentage). This option position is covered because if the call options are exercised, the investors owns 1,000 shares of Apple, which he or she can deliver to the option contract owner(s) (if the stock is called).
Let’s take a step back and discuss what an option contract is and how it works. First, an option contract is just that—a contract. It is not a stock or any other security, but is a contract derived from or based on a security; in this case a stock (Apple in our example). Owning an option contract gives the owner the right to buy (call) or sell (put) the underlying security at at specified price (strike price) during a specified period of time (until the expiration date). The price that is paid to purchase the contract is called the premium. The owner buys the contract and for each and every buyer, there must be a seller. The seller is on the opposite side of the contract, so whatever the buyer has the right to do is the obligation of the seller.
Returning to our example, if the investor who owns Apple wants to sell 10 call contracts on Apple, he or she is selling the right to call the 1,000 shares of Apple (buy it) at the strike price ($260 per share in the example). The person who buys the 10 call options from this investor has the right (but is not obligated) to buy the 1,000 shares of Apple at $260, and the seller of the option contracts is obligated to sell at $260, if the buyer wants to buy.
I know this can get confusing, so let’s look at another example that might make more sense. Let’s say my neighbor has a car for sale for $20,000. I am interested in the car, but I’m not sure if I want to buy it. I tell my neighbor that I will give him $100 for the right to buy the car for the next week so he will not sell the car to someone else for the next week while I think about it. I now have a call option on the neighbor’s car with a strike price of $20,000, with an expiration date one week from today, and a premium of $100. My neighbor is obligated to sell me the car for $20,000 during the next week, even if he gets an offer for $30,000, while I have the right to buy the car at $20,000 for the next week, but I am not obligated to buy it.
Returning again to our investor and his covered call position on Apple, we see that he was able to sell 10 calls for $25,000, or almost 10% of the current value of his position. He (or she) is obligated to sell the 1,000 Apple shares at $260 a share up until October 15th, the expiration date. Three things can happen to the stock—it can stay the same, go up, or go down. Let’s look at what could happen in all three situations. First, if the stock stays at $260, which is the strike price of the option, the call option will most likely expire worthless for the buyer, and the seller—the owner of the 1,000 shares of Apple, will keep the stock and the premium of $25,000. The investor could then sell another call option against his position, and earn another premium. The call owner could call the stock at $260, but it would be unlikely since, if they really want to own the stock, it is easier to go into the open market and buy it (there is no financial benefit since the option strike price and the share price are the same).
If the stock goes up and stays that way to the expiration date, the stock will get called, meaning that the owner of the stock will have to sell it at the strike price of $260 per share, no matter where the stock is trading on the expiration date. Keep in mind also that the stock could get called any time during the life of the option contract and not just on the expiration date, although most of the time that is when the option contract would be exercised, if the stock is above the strike price. Although the owner of the stock will have to sell at $260, they also received $25 per share when they sold the call options, so they are actually getting $285 per share. So, unless the stock is trading above $285, selling the call will not have cost them any money (ignoring taxes which are hard to ignore; I’ll talk about this more below).
The other possibility is that the stock could go down. If the stock is below the strike price at expiration, it will not get called. This means that the seller of the option gets to keep the stock and the premium of $25,000 (the option seller gets to keep the premium no matter what). The option premium also acts as a hedge, offsetting any losses that would otherwise be incurred, if the stock falls in price. For example, if Apple falls from $260 to $240, and the owner of the stock had not sold the calls, he or she would be down $20 per share on 1,000 share, or $20,000. With the option sale, the $25,000 premium more than offsets the loss, and the stock owner, despite having had the stock fall by $20 per share, is still ahead by $5,000 ($25,000 option premium less the $20,000 loss on the stock).
Once the contract expires, the stock owner can then sell another call, if he or she wishes, and the whole process starts again. In most cases, what the option seller is hoping for is that the stock will be below the strike at expiration (but not by a lot) so that the stock is not called and therefore they get to keep the stock and the premium, avoiding any tax consequences that might otherwise apply if the stock were sold. Many of my clients will sell options against the same stock positions over and over again, and some purchase stocks specifically so that they can sell calls against the position.
There are, of course, potential tax consequences that can be especially onerous if the stock position has a low cost-basis. Once the option contract has been sold, the stock owner is obligated to sell the stock at the strike price, whether they want to or not, unless they buy the option contract back. Investors who are opposed to the possibility of paying capital gains taxes should understand that selling covered calls can result in realizing capital gains.
It is also possible to sell put options. Selling a put gives the buyer of the put the right to sell you (the put seller) the stock at the strike price. So, if you sold a put on Apple with a strike price of $260 per share at $25 (premium), you would be obligated for the life of the option contract to buy Apple at $260. This is a good strategy to use during times of high volatility (like now) if the stock is one that the investor wants to own anyway. Selling the put has the effect of lowering the purchase price by the amount of the premium ($25 per share in our example). In this example, one could say that the cost would be $260 per share less the $25 premium, or $235 per share, if the put contract is exercised (if the put is not exercised, the seller gets to keep the premium and doesn’t have to buy the stock).
Options are not for everyone, and as I have discussed there can be tax consequences. Investors who are interested in these strategies should can a qualified advisor who is an expert on options. Used appropriately, they can enhance returns, reduce portfolio risk, and generate income. I hope this has been informative and not completely confusing. If you have questions, give me a call or send me an email, and I’ll do my best to answer.