This article is directed at those who are new to the option market, consider themselves proficient at valuing stocks and would like to squeeze some additional income from current or possible future holdings. It is not a comprehensive look at options but a simple strategy to generate additional income through stocks you own or stocks you would like to own at the right price through options.
This is not appropriate for everyone but I’ve had success with this strategy for many years and decided to share some of my experience. This is not a day trading strategy. It takes patience and should only be executed when opportunity presents itself which we’ll discuss later in terms of targets.
Before we get started let’s review some option facts that serve as the foundation for this strategy:
- You can give someone the option (pardon the pun) to buy your stock at a set price by some future date. Ok so what’s in it for you? Well the other party will pay you for this right. This is known as a covered call. The word covered indicates you own the stock you are willing to sell. You are the call seller and the other party is the buyer. You may have heard the term write in the option world. This is just another way to say you are the seller (or writer) of the call.
- You have the right to buy stock at a set price at some future date and the other party will pay you for this right. This is known as selling (writer of) a put. I will add one stipulation; always have the cash available to buy this stock if needed. Do not use margin unless you are experienced and successful in both the option and stock markets and understand leverage risk. Since you have the cash to cover any stock purchase this is known as a covered put.
These are the pillars that support the strategy of generating income using options. The discussion is broken down in the following order:
- Option Lingo
- Getting Started
- Covered Calls
- Covered Puts
- Tax Consequences
- Final Thoughts
If you are familiar with options you can skip this section. You will hear that an option is a contract between two parties, which it is, but you will see no written contract; nothing needs to be signed etc. between the parties. All you need to know is once your brokerage account is set up to trade options, buying and selling is done with the same ease as buying and selling stocks. Here is a view displaying Level 3 Communications (LVLT) options with the month of October expanded and an order form below it
A few definitions for terms used going forward:
- Underlying security – This is the stock (LVLT in the above example) that must be delivered if the option is exercised
- Strike – The price where the buyer of an option can purchase or sell the underlying security (43-48 shown for October above). The buyer of a call has the right to purchase and the buyer of a put to sell the stock.
- Expiration – The date the option expires (shown in the figure above)
- Premium – The price paid for the option (equal to intrinsic plus extrinsic value).
- In the money (ITM) – A call is ITM if the strike is less than the market price for the underlying security and a put is ITM if the strike is greater than the market price.
- Out of the money (OTM) – A call is OTM if the strike is more than the market price for the underlying security and a put is OTM if the strike is less than the market price.
- Intrinsic Value – Applies to ITM options. i.e. equal to the difference between the strike and the underlying security price. If OTM than intrinsic value is zero.
- Extrinsic Value – The difference between the option’s market price and its intrinsic value.
Premiums follow time risk. The longer the time line the higher the risk which in turn produces a higher extrinsic value (which is added to the intrinsic value for ITM options), i.e. November premiums are higher than October etc..
The above figure show the months listed for available options for Level 3 Communications (LVLT) with the month of October expanded to show various strike prices. We are showing six strike prices for October for illustration purposes but there are additional strike prices available than what is shown.
The option prices are shown as per share numbers however you trade options in contracts. One contract is equivalent to 100 shares. Do NOT put an order in reflecting the share amount. If you put an order in for 1000 shares than your enter a quantity of 10. If you enter 1000 than you are talking about 100,000 shares!
Before applying this method you must have a procedure in place to determine the fair value of the stock you are targeting which is not a subject of this article. Once you have established fair value you then establish what prices you are willing to purchase, or sell, the stock. We’ll refer to these price points as the buy target and sell target going forward. Targets will vary by investor since investor risk tolerance is a reflection of differing financial situations, age, etc. If you do not have any procedure established to determine fair value you should not be trading options.
I’ve written a program in Excel 2010 that helps establish these values. A video describing the program can be found at http://youtu.be/9L_bwJXX75k . This template is available to supporters of my website. All that counts is you have a proven method to establish fair value in line with your risk tolerance then you can start generating income using options.
The rationale behind the covered call strategy is as follows. As stated earlier you must have a system to establish buy and sell targets based on fair value calculations. This helps take emotions out of buy and sell decisions. Instead of selling the stock when it hits your sell target you can use covered calls to increase income and collect any dividends while the call remains outstanding. In many cases the stock settles back toward fair value; below the sell target in which case you can continue to collect any dividends and keep the premium paid once the option expires. Should the stock approach your sell target after expiration rinse and repeat. If called out your proceeds from the sale of stock plus option premiums should exceed your sell target.
Hypothetical Example: Using the figure given earlier for LVLT (shown trading at $45.39) your sell target is $45. You could sell a short term call with a strike of $45. The bid is at $1.30 so in this example you sell 10 contracts (represents 1000 shares) and you receive proceeds of 1000 x 1.30 = $1300.00 (excluding commissions and fees). NOTE: Always use limit orders. If the stock closed above $45 by October 18, 2014 than you will be called out of the stock, i.e., you must sell the stock at $45 per share. Your proceeds are $45 + $1.30 or $46.30 (minus fees and commissions) satisfying your sell target. If the price falls below $45 on October 18, 2014 than the $1300.00 is additional income since the option expired. If the stock price is trading close to the sell target you can write another Call for November or December.
Below are a few real examples of some of my actual trades (including risks discussed under covered puts) to further illustrate the process.
Real Example 1: RR Donnelley & Sons (RRD). I had established a fair value of $17.20 and a sell target of $19.10. This stock pays an annual dividend of $1.04. I sold covered calls on 7/30/13. The stock traded in a range from $16.44 to $18.94 and closed at $18.93. Consistent will my sell target I chose a strike price of $19. The only question was what expiration date to choose. I chose December 2013 and received $0.70 per share, i.e., giving another party the right to purchase my stock at $19.00 if the stock was trading at or above this amount at the close of the third Friday in December 2013 (The option expires on the third Saturday). The stock closed at $18.67 on December 21, i.e., worthless to the buyer of the call; meaning the option expired and I keep the $0.70 per share paid and the stock. The buyer of the call is not going to “call” my stock for $19 per share when they can get it cheaper on the open market so the option expires worthless (to them). I continue to receive the dividend and continue to sell covered calls as the opportunity presents itself. This is where patience comes into play. As of this writing option income from RRD has been $2.21 per share (excludes dividends).
Real Example 2: TEVA Pharmaceutical Industries (TEVA). I had established a fair value of $45.1 and a sell target of $48.6 at the time. I sold covered calls on 2/20/14. The stock traded in a range from $46.42 to $49.23 and closed at $48.20. I chose a June 2014 strike price of $47.50 which commanded a premium of $3.20 per share. The stock closed at $52.97 on June 20 and I was called out of my position, i.e., sold the stock for $47.50. My real sale was $47.50 + $3.20 or $50.70. Total option premium generated over time was $5.80 per share (excludes dividends). One could argue using hindsight that holding the stock based on this one trade might have been the better choice. Remember once you establish a stock is overvalued (exceeds your sell target) you are committed to sell options or no options.
The purpose of this strategy is to squeeze more income out of the holdings rather than just selling at the target sell price. Everyone’s sell target will vary since we all look through different lenses when analyzing fair value.
The rationale behind selling covered puts is only activated when the stock approaches your buy target.
Hypothetical Example: Using the figure given earlier for LVLT (shown trading at $45.39) your buy target is $44.10. You could sell a short term put with a strike of $45. The bid is at $0.95 (all extrinsic value since it is OTM) so in this example you sell 10 contracts (represents 1000 shares) and you receive proceeds of 1000 x .95 = $950.00 (excluding commissions and fees). If the stock closed below $45 by October 18, 2014 than you will be put the stock, i.e., you must purchase the stock at $45 per share. Your basis cost is $45 – $0.95 or $44.05 (plus fees and commissions) satisfying your buy target. If the price exceeds $45 on October 18, 2014 than the $950.00 is additional income since the option expired. If the stock price is trading close to the buy target you can write another Put for November or December.
Real Example 1: Level 3 Communications (LVLT). As of this writing I’ve established a fair value of $55.5 and a buy target of $39.4 (was $38 at the time of this example). The much lower buy target reflects my risk tolerance; I am conservative (although at times it doesn’t work out that way as you’ll see in example 2). On May 20, 2014 I sold September 2014 $38 puts for $1.15. The stock traded in a range from $43.40 to $44.16 and closed at $43.83. The stock closed at $47.23 on September 19, i.e., worthless to the buyer of the put; meaning the option expired and I keep the premium paid but do not get to add to my stock position since the buyer is not going to require me to purchase their stock for less than what they would get from selling on the market. This year I have accumulated premiums in this stock of $6.10 per share and presently have outstanding covered puts with strikes of $40 and $41 that expire December 2014. This is one stock where I established a position on the open market than moved to options when the stock exceeded the buy target.
Real Example 2: This example shows how things can go wrong. Nu Skin Enterprises Inc. (NUS). On July 18, 2014 the stock was trading at about $62 close to my buy target. I sold a covered December put for $6.20 with a strike price of $60. On August 6 the stock plummeted down to $46.52. The stock now exceeded my sell target due to changes announced by management so I bought the put back for a loss. What went wrong; are there lessons to be learned? NUS encountered inventory problems which masked real growth. My analysis overlooked inventory red flags which have since been corrected. Lesson learned and accounted for in future analysis. On the bright side (ok, not that bright) is the loss was less than if the stock was bought at the price when the put was sold. That said any loss is still painful and if you’ve been in the market for a while you already know the occasional loss is a given. You just need to have more wins as any investor would tell you. Bottom line is you’re not going to win every trade in options or stocks. It’s important to learn what went wrong, incorporate it going forward and move on. Another lesson is to expand your sources as a check. There was an article on Seeking Alpha that highlighted the inventory issues before it exploded and written by someone who is no stranger to financial shenanigans; unfortunately I had not read it; then again hind sight is 20/20.
Remember if you are using puts on stocks you feel you must absolutely own if the stock falls below your buy target you will not have the chance to own using this strategy unless the stock is trading below the strike price by the expiration date. You could limit this by
- Writing puts for a portion of what you intend to buy and make an open market purchase for the remaining portion should the stock price trigger your buy target.
- Write puts that are well ITM so the strike minus the premium is below the buy target although there is still no guarantee you will be put the stock.
If the option expires worthless your income is taxed as a short term gain if the holding period did not qualify as long term which it normally does not using this strategy.
If you are called out the income (premium received) from the option sale is added to any gain /loss from the stock. You are taxed based on the holding period of the stock.
If you are put the stock the premium received is subtracted from the purchase price of the stock which serves as the basis cost. There is no tax due until the stock is sold.
Here are some IRS links written to make things look as complicated as possible.
I am not a CPA so you should consult a professional to examine your situation.
If a stock is approaching one of your targets and you have not checked the earnings, news, etc., before executing an option, or the stock makes an unexpected swing one way or the other then go back and update your analysis to be sure your targets and/or fair value have not changed before executing this strategy. Check for major news events, company related or other.
I’ve found that many times the fundamentals have changed to the point of not going ahead with this strategy. A case in point not discussed above is Microsoft. I’ve held MSFT for over seven years now. During the period from 2005 through 2008 the income from options exceeded the yearly dividends. In the last two years MSFT has not met the buy or sell targets which changed over time (increased) so there has been no additional income associated with MSFT other than the dividends.
Bottom line is to be patient, disciplined and avoid trading anything on your emotions. Stick to your analysis and your wins over the long term will far outnumber the losses. Hope you enjoyed this point of view along with some personal experience. Feel free to post comments pro and con.