Using Options to Turbocharge Your Returns

USING OPTIONS TO TURBOCHARGE YOUR RETURNS

For many investors, options are scary. These investors have heard horror stories about people who got burned trading options, or that they’re complicated, or that they’re not for the little guy.

There are complex options strategies, and people do lose money when they speculate (there are also many investors who make money) with options. Most people who lose money trading options do so because they buy options. In a moment, I’m going to show you how to be the seller, the person who is more often on the winning side of the trade.

The strategy that I’m going to show you is simple, carries no risk to your principal (only opportunity risk), and can boost your returns by double digits annually.

First let’s go over definitions of the two kinds of options: puts and calls.

Put: A contract giving the buyer of the option the right, but not the obligation, to sell stock to the seller of the option at a specified price by a specified date.

Call: A contract giving the buyer of the option the right, but not the obligation, to buy stock from the seller of the option at a specified price by a specified date.

Let’s look at an example.

Shares of Microsoft are trading at $26. An investor buys the January $30 call for $1. This means the call buyer has the right (but not the obligation) to demand the shares of Microsoft at $30 from the call seller at any time between now and the third Friday in January. (Options expire on the third Friday of the month.) That $30 price is called the strike price—the price at which the seller of the call agrees to sell the stock to the buyer if demanded.

Why would someone want to enter into a contract to buy shares of Microsoft at $30 in the future if today he can buy them at $26? Because he thinks that by January, the stock is going to be higher than $30. Maybe he thinks it will be $35 by then, and to secure the right to buy it at $30, it will only cost $1.

If Microsoft is above $30 by January, the call buyer can demand the stock at $30, or he can sell his call at a profit. If the stock is trading at $35, he should be able to sell the call for at least $5, turning his $1 per share investment into $5.

Buying the call allows him to participate in Microsoft’s upside while risking only $1 per share instead of $30. However, unlike owning Microsoft shares, the call option has an expiration date.

If the stock does not go above $30, the call expires worthless and the seller of the call keeps the $1.

Puts act the same way, only the buyer of the put has the right (but not the obligation) to sell the stock at a certain price. If an investor owns Microsoft at $26, he may buy a $24 put to limit his losses.

If tomorrow it’s discovered that Microsoft’s code has been secretly stealing the personal information from every PC user in the world, the government shuts the company down and the stock falls to zero, the buyer of the put can force the seller to buy his shares at $24.If you want to learn all about options and strategies, there are tons of books on the subject, including Get Rich with Options (John Wiley & Sons, 2007) by my friend and colleague Lee Lowell.

Covered Calls: The Espresso of Income Investing

Investing in dividend stocks is like a good strong cup of coffee for your portfolio. It puts a little giddyap in your finances and helps you achieve your goals. Just like a cup of coffee gives you a jump start in the morning.

Some people need a little bit more help, particularly in the afternoon or maybe at night if they’re going out. So rather than a cup of regular coffee, they kick it into overdrive and order an espresso.

A regular cup of coffee really doesn’t do much for me. A shot of espresso, however, is like rocket fuel. I’m raring to go.

That’s what a covered call is to your portfolio. It’s like a shot of espresso to increase your returns.

Covered call: When an investor owns shares of a company and sells a call option against those shares, in effect agreeing to sell the shares at a predetermined price by a specified date at the call buyer's demand.

When an investor sells a covered call, he already owns the stock he is selling the call against, and agrees to sell the stock to the call buyer at the strike price (the specified price) by a certain date.

So going back to our Microsoft example, if you own the stock at $26 and sell the January $30 (the strike price) call for $1 (per share), you will have to sell your stock to the call buyer for $30 by the third Friday in January if she exercises the contract (demands it).

Let’s assume that it is July, so January is six months away. Let’s look at some scenarios.

Best-case scenario. Microsoft stock trades up to $29.99 at expiration (third Friday in January). The call expires worthless and you keep the $1 per share. You’ve earned $0.40 in dividends during that period as Microsoft pays a quarterly dividend of $0.20 per share. The stock is also up $3.99 since you bought it.

Worst-case scenario. It is discovered that Microsoft has been cooking its books for years, Bill Gates and the rest of the executives go to prison and the stock falls to zero. You’ll at least get $1 out of the deal, as you’ll keep the $1 from the now-worthless call. The call is worthless because no one is going to force you to sell a stock to him for $30, when the price of the stock is below $30.

The $1 helps protect the investor from some downside. And if you’re a long-term investor, particularly if you’re interested in the dividend or reinvesting the dividend, the stock’s decline doesn’t matter much to you. It matters only when you’re ready to sell. In the meantime, if the stock slips to $23, you’re still reinvesting the dividends at a lower price, and, oh, yeah, you get to keep the $1 per share, which is equivalent of another 3.8%.

Annoying scenario. Microsoft trades up to $33. Your call buyer can exercise her option forcing you to sell your shares to her for $30. Don’t forget, you’ll also keep the $1 she paid you, so it’s like you’re selling it for $31. Even though the stock is seven points higher, you still made $5 ($4 profit plus $1 for the call) on a $26 stock in six months, or 19.2%, so it’s not the end of the world.

But you did miss out on greater profits, which is the risk when you sell a call. Imagine if you made the same transaction but instead, Apple bought Microsoft for $50 per share. You’d be a little more annoyed that you’re missing out on all that extra profit.

As I’ve said repeatedly, there’s no such thing as a free lunch on Wall Street. If you’re going to make an easy $1 per share by selling a call, you’re taking on the risk that you’ll have to sell your stock at a lower price than where it might trade in the future.

That doesn’t mean you’ll suffer a loss, though. Let’s be very clear about that. If you sell a call at a strike price that is higher than the price you paid for the stock, you cannot suffer a loss as a result of the call being exercised. That’s an important concept to understand.

You can, of course, suffer a loss if the stock goes lower and you sell it. But selling a call with a strike price above what you paid for it cannot result in a loss to you, only a loss of opportunity if the stock goes higher than your strike price.

Options: Where 1 Equals 100

Option contracts are conducted in groups of 100 shares. If you sell one call, you are agreeing to sell 100 shares of stock. The $1 per share for selling the call would result in $100 cash being put into your account. If the option was exercised and you had to sell your shares at $30, you would receive $3,000 because you'd be getting paid $30 per share for 100 shares.

Even if the stock price is above the strike of the call you sold, you don’t always have to sell your stock. If Microsoft is trading at $33 and you’ve sold the January $30 call, rather than selling your stock, you can buy back the call, albeit at a loss. So perhaps you’ll have to pay $3.50 for the call that you sold for $1, incurring a loss of $2.50 per share. But you may determine that it’s worth it if you own the stock, are reinvesting the dividends, and building up a nest egg.

Or you may even be able to buy back the call at a profit. The values of options decay as the expiration date gets closer. If Microsoft is trading at $30.25 the day before expiration, you may be able to buy back the calls at $0.50, in which case you get to keep your stock and still make a $0.50 profit on the call that you originally sold for $1.

Option Prices

A few key variables affect options prices. They include how far away the stock is from the strike price, time, and volatility.

In the money: A call option whose stock is above the strike price or a put option whose stock is below the strike price. A $30 call and a $40 put would be in the money if the stock is trading at $35.

At the money: An option whose stock is at the strike price. A $35 call and $35 put would be at the money if the stock is trading at $35.

Out of the money: A call option whose stock is below the strike price or a put option whose stock is above the strike price. A $40 call and $30 put would be out of the money if the stock is trading at $35.

In in-the-money call option is a call whose strike price is below the current stock price.

Example: Freeport McMoran Copper & Gold (NYSE: FCX) is trading at $37. A January $35 call is in the money because the strike price ($35) is below the current price ($37). The option is currently trading at $8. That’s because the stock is already $2 in the money. The call has to be worth at least $2, because that’s the profit an owner of the stock could make automatically upon purchase of the stock at $35. The remaining $6 is due to volatility, which we’ll talk about in a moment.

If you were to sell the January $37 call, it would be at the money, because the current price and the strike price are the same. That call goes for $7, all of which is due to volatility. Someone who exercised the option and bought the stock at $37 would not have a gain or loss with the stock trading at the same price.

The January $40 call is out of the money because the $40 strike is above the current price of $37. The $40 strike will cost you $5.75, again all of which is due to volatility.

So now let’s talk about volatility.

Volatility: An Option Seller’s Best Friend If you sell calls against your stocks, forget the family dog; volatility is your best friend. Volatility is a measure of how much the price of a stock fluctuates. The more it bounces around, the more likely an options strike price will be met, which is why stocks that are more volatile have higher-priced options.

Think of it this way: If you are buying an option that has very little chance of actually hitting the strike price, you probably won’t be willing to pay very much for it. But if a stock is up three points one day, down six the next, up five the following day, and so on, there’s a better chance your option will hit the strike price and become profitable. As a result of the better odds, you will have to pay a higher price.

There have been many studies on volatility, and you can read all about it in various books about options, but I wanted to give you a simple explanation.

Freeport McMoran happens to be a volatile stock because it tends to react to price swings in copper and gold. Another stock, such as Potash (NYSE: POT), might be in a similar price range, but its options are much cheaper because the stock isn’t as volatile.

When you sell calls on volatile stocks, you collect a bigger payment from the buyer. The fact that it’s more volatile increases the chance that your call could be exercised and you’ll have to surrender your stock, but you’re getting paid well to take that risk.

For example, if you bought Freeport McMoran at $37 and sold the January $40 calls for $5.75, you’ll make 15.5% on your money just from the calls alone ($5.75 divided by $37). If you own the stock for a year while you’re waiting for expiration of the call, you’d get paid another $1 in dividends, increasing your return to 18.2%. Finally, if the stock is above $40 and gets called away from you, you’d make 26.4% in one year.

Of course, the risk is that the stock is trading at $50 and you have to sell it for $40. But the fact that you made $1 in dividends plus $5.75 from the call can take away some of the pain of the missed opportunity.

Plus, if the stock goes against you and falls to $32, you’re still in the black because you collected the $5.75 from the call and the $1 in dividends. The call essentially lowers your breakeven price from $37 down to $31.25.

Time Is On Your Side Time is the other component in an option’s price. The longer the amount of time until expiration, the more the option will be worth. Makes sense. After all, the farther away expiration is, the more time the stock has to hit the strike price. A stock with an option that expires in just a few weeks may have little chance of hitting an out-of-the-money strike price. Therefore, it would be very inexpensive.

Option prices decay with time. If a stock never moved a penny from the time you sold an option on it, you would see the option price slowly fall with the passage of time. As the expiration date gets closer, the price decline picks up momentum.

That’s why I say time is on your side as a call seller. If you sell a call for a nice price, eventually the time component of the price will deteriorate. The option price could go higher if the stock gets more volatile or if the stock price climbs, but the time element will dwindle to zero like the sand in an hourglass.

In fact, it’s possible you could sell an out-of-the-money call, see the stock rise to go in the money, and still make a profit.

Here’s how:

In our Freeport McMoran example, with the stock trading at $37 in February, you sell the January $40 call for $5.75. In late December, the stock is trading at $42. Because so much time has expired over the life of the option contract, there is very little time value left. So the January $40 call, which you sold for $5.75, may now be trading at $3, even though the stock is $2 in the money.

You could buy back the call for a profit of $2.75 ($5.75 - $3) and hang on to your stock, which is now trading at $42.

Who Should Sell Covered Calls? Because the seller of the covered call may have to give up his stock, this strategy is more appropriate for investors who are seeking current income as opposed to those who are trying to build wealth via dividend reinvestment.

If you’re trying to build a nest egg with a time horizon of ten years, by reinvesting dividends, chances are that within those ten years, we’ll hit a bull market, stocks will rise, and any stock you sold covered calls against will be called away from you, disrupting the compounding dividend machine.

Of course, you could always take the money from the sale of the stock and put it into another dividend-paying stock. But one of the appealing aspects of the dividend reinvestment method is how easy it is and how little time you have to devote to it.

Also, there is no way of automatically reinvesting the money you receive from selling the calls back into the stock. That’s not a huge problem, but buying more stock with the money you receive from the calls is another step you’d have to take if you were trying to build up your holdings in that particular stock.

If you’re selling covered calls against your position, you definitely want to be on top of it.

But the time commitment can certainly be worth it. If you’re looking for current income, this is a terrific strategy to boost your returns. As you saw in the Freeport McMoran example, if the stock gets called away from you, you’d have earned 26.4% instead of 10.8% from the dividends and price appreciation. If you weren’t forced to sell the stock, you’d have earned an extra 15.6% on a stock you were planning on hanging on to anyway in order to receive the dividend.

And if the stock gets called away from you, just take your gains and move on to the next dividend stock.

The only real downside is when the stock files way past the strike price. That can be frustrating as you miss out on those additional profits. And chances are if you sell enough covered calls, it will happen to you. But over the long haul, it’s worth putting in the extra time to manage your positions to get those extra double-digit returns year in and year out of your stocks.

Now, what happens if your stock takes a dive and you want to dump it but you sold a call against it? No problem, you just buy it back, usually much cheaper. If Freeport McMoran falls to $33, your $40 call will likely fall right along with it. The decline of the call won’t match that of the stock dollar for dollar, because, remember, an option’s price is also made up of time and volatility components. But it should be lower, and you can buy back the call at a profit and then sell your stock.

For example, if you sold the Freeport McMoran $40 call for $5.75 and the stock drops to $33, the option may be trading at $2.25. You’d buy it back and profit $3.50 ($5.75 - $2.25). The $3.50 profit on the calls offset some of the $4 loss on the stock.

Espresso isn’t for everyone. Some people get jittery from all that caffeine. But others love the extra lift it provides. Covered calls are similar. Some investors don’t want to commit the extra time to studying and managing their options positions. But for those who do, the extra boost to their portfolio’s returns can be grande (sorry, I couldn’t resist).

Selling Puts

Some investors are big fans of selling naked puts. Unlike an out-of-the-money covered call in which you already own the security and you can’t lose any money, selling a naked put involves risk. It’s called naked because it’s not tied to a stock. If you were short the stock and sold the put, it would not be naked.

When you sell a put, the buyer has the right to sell you the stock at the strike price before or at expiration. Therefore, when you sell a put, you need to be prepared to buy the stock.

Put sellers typically sell out-of-the-money puts—a strike price below the current market price.

In return, you receive the cash that the buyer pays for the put. If the stock does not reach the put’s strike price, you keep the cash. If the put does wind up in the money, you may be forced to buy the stock, which can get expensive.

Think of it this way, the put buyer is purchasing insurance on her stock. If the stock price goes down, she is protected by the puts. You, as the put seller, are the insurance company. You collect and keep the insurance premium and take on the risk if something goes wrong.

Let’s say Merck (NYSE: MRK) is trading at $43 and you sell five puts on Merck with a strike price of $40 for $1 per contract. Since option contracts represent 100 shares, you’ll receive $100 per contract, or $500. If the Merck puts are in the money (below $40) and you are required to buy the stock, you will need to pay $20,000 (500 shares X $40 per share).

Investors who sell naked puts should do so only if they want to own the underlying stock at the strike price where the puts are sold. They also need to have the money available to purchase the stock if it is put (sold) to them.

Put sellers love this strategy because, in a bull market, it’s like free money. They collect the cash from selling the puts and are not required to own any stock. (However, they also don’t participate in any upside if the stock goes higher.) If the stock slides, they not only pick up the cash but also buy shares at a lower price than they would have earlier.

Using our Merck example: If Merck is trading at $43 and an investor sells the puts with a $40 strike and the stock is put to them at $40, their net cost will be $39. Don’t forget, they received the $1 per share for selling the put. When Merck was trading at $45, if the investor would have been happy to own the stock at $39, the trade might be attractive.

The risk is that Merck could be sharply lower by the time the option expires. If one of Merck’s drugs is shown to have nasty side effects and the stock slides to $30, the put seller is still on the hook to buy it at $40. Like the covered call, you can always buy the put back at a loss if the trade goes against you—before the stock is put to you.

A put selling strategy is appealing to dividend investors who see a stock they want to buy but feel it’s overpriced. They can sell the put and essentially be paid to wait to see if the stock price comes down. If it does, the investor can get the price she wants. If not, at least she collected some income during the process.

While I like put selling, it’s more complicated than selling covered calls. For most investors, the covered call strategy is a better one for a very important reason: The risk is lower. The last thing you want to do when you’re conservatively investing for income and for the future is to get blown up by an options trade.

When you write covered calls, other than your stock going down (which could happen regardless of selling calls), the worst that could happen is that your stock takes off and you’re forced to sell it and miss out on some upside, or you sell the calls at a loss in order to keep the gains in the stock.

Summary

• Selling a covered call is a great way to boost the income you receive from your stock holdings.
• When you sell a covered call, it gives the buyer the right, but not the obligation, to buy your stock from you at a specified price (strike price) by a certain date (expiration date).
• When you sell an out-of-the-money covered call, your only risk is opportunity risk (although you can choose to buy the call back at a loss if you don’t want to give up your stock).
• You need to actively monitor your covered call positions. A covered call strategy requires more attention by you so you’re no longer snoozing your way to wealth.
• Selling out-of-the-money naked puts allows you to get paid to wait and see if a stock you’re interested in comes down in price, but it carries more risk than covered calls.
• Coffee doesn’t do a thing for me. Espresso, however, turns me into Jim Carrey on uppers.