I’ve written numerous articles on options trading and how one can leverage options over the long-term to mitigate risk, generate income and accentuate returns. Leveraging options to supplement portfolio returns can make a meaningful impact to overall returns, especially over the long-term. Here, I’ll focus on covered calls and covered puts with corresponding lessons learned over the course of the past year with empirical data.
Covered calls are intended to leverage a stock position while extracting value on a consistent basis via selling option contracts against that position and collecting premium income in the process. I liken this to a landlord renting a room for monthly income however in this case one is renting the stock. The option contract is structured with the option seller (stock owner) collecting a premium in exchange for the right for the option buyer to purchase the shares of interest at an agreed upon price by an agreed upon date for a premium (income that the option seller will receive). In this scenario, the stock owner doesn't believe that the shares will appreciate beyond the agreed upon price and thus be able to collect income while retaining the shares and dividend rights. The option buyer believes that the shares will appreciate beyond the agreed upon price and be able to buy the shares at a lower price than the market currently trades.
Covered puts involve leveraging a cash position that one currently has on hand and collecting a premium in exchange for the obligation to purchase one’s shares at an agreed upon price prior to an agreed upon date. If the stock falls below the agreed upon price prior to the agreed upon date then the individual that bought the contract from you will force the obligation (that you agreed to) for you to purchase the shares. In this case (when the stock falls throughout the contract lifespan), the shares can be sold to you (the put option seller) at a higher price than the market. However if the shares rise in value then the shares will remain with the owner and the put option seller will keep the premium income and the cash earmarked for the potential purchase of the shares will be freed. Why exercise the contract and sell the shares to you (option seller) at a lower price when one can sell the shares on the open market at a higher price?
Covered Call Objectives:
Collecting premium income: "Renting" out your stock for monthly income can be a great income generator over the long term. Assuming disciplined options are sold, risk of relinquishing the stock in question decreases and retention of the shares and premium income increases.
Mitigating risk: As the stock in question trades sideways and/or decreases in value, the premiums over time will mitigate the lack of appreciation and/or the decrease in value.
Accentuating returns: As the stock trades higher over time, extracting additional value over the long run will accentuate these returns in a meaningful manner.
Covered Put Objectives:
Initiate a position: Initiate a position in a stock at a lower price in the future than the stock currently trades today via receiving a premium which will reduce the effective purchase price to below the current market value.
Income: Identify stocks that have corrected and sell a covered put to receive a premium with the anticipation of the stock appreciating near the agreed upon contract price to capture the premium income and exit the contact. Thus no shares purchased and gains via premium income are realized. The earmarked cash plus the premium income can now be repurposed for subsequent trades.
Lower Cost Basis: Adding to an existing position via a covered put contract – when a long position corrects, one can add to his position to lower the cost basis with the intent of being assigned shares at a lower effective price than they currently trade when factoring in the premium income. Essentially locking in this downward movement and being assigned shares to lower one’s cost basis when combined with a preexisting position.
Covered Calls – Successes (Facebook and Nike)
I've had many successful covered call contracts however it's very difficult to continuously generate income without the shares moving against you eventually. Here are two examples of long-term options income being generated on two of my long-term holdings, Facebook (FB) and Nike (NKE). My strategy is to sell options into strength to decrease the possibility of relinquishing my shares while extracting income and retaining the shares. For FB, I've been able to generate an additional $5.78 per share in income or $578 in cash leveraging this long-term position. For NKE, I've been able to generate an additional $1.94 per share in income or $194 in cash leveraging this long-term position while collecting the dividend and reinvesting over time. This translates into $772 in cash generation leveraging these two positions.
Covered Calls – Lessons Learned (Apple and AbbVie)
Apple (AAPL) and AbbVie (ABBV) were very difficult pills to swallow with unrealized gains far beyond the relinquished prices. As Apple started to trend higher after recovering from the low $90 range, I decided to engage in covered calls and had some wins however the upward trend was too strong and I relinquished shares at $127 only to watch the shares rise to $160! I missed out on $33 per share or $3,300 in appreciation based on this 100-share block! ABBV had moved from higher from the low $60 range to the mid $70 range and had some wins however the upward trend was too strong once again and I relinquished shares at $73 only to watch the shares rise to $96 with no news really at all! I missed out on $23 per share or $2,300 in appreciation based on this 100-share block! This translates into $5,400 in total lost unrealized gains on these two long term positions. Hindsight is 20/20 and as a result I prefer to engage in covered puts as theoretically stocks and move infinitely higher.
Covered Puts - Successes
I typically select high quality, large-cap household names when engaging in selling covered puts. Typically, I identify companies that have sold-off in a meaningful way due to extraneous circumstances or a marginal miss in an earnings report. These companies are ones that typically pay dividends, engage in share buybacks, acquisitive mindset and still growing revenues. Examples of these opportunities include but are not limited to Starbucks (SBUX), Disney (DIS), CVS Health (CVS), Apple (AAPL), Bristol-Myers Squibb (BMY), Nike (NKE) and Target (TGT) to name a few companies that have witnessed huge sell-offs while the underlying business model remains fundamentally intact. Inevitably, these stocks appreciate to pre-sell off levels usually within a short period of time. Below is a laundry list of examples over the past year where assignment is very rare and in the event of being assigned, I was able to still sell at a profit (Figure 1). Figure 1 shows a subset of my 2017 covered put contacts with results and out of the most recent 13 contracts, 12 of them have been wins (92% win rate) with a premium capture of 55% and a net income gain of $4,547 (including the FB pending contract as this is already in-the-money).
Figure 1 – Subset of 2017 covered put contracts and results
Covered calls and covered put options can be very valuable regardless of objective since these instruments provide optionality with regard to generating income, mitigating risk, accentuating returns, initiating a position, generating income and lowering cost basis of an existing long-term position. I’ve shown empirical examples of each option strategy behind the trades. Covered calls are inherently more risky in the sense that stocks can infinitely increase through the agreed upon price and the shares will be relinquished as in the case with AAPL and ABBV. With regard to covered puts, limiting one’s option trading to large-cap, dividend paying household names can mitigate risk as these companies have history of resiliency, dividends, share buybacks and major acquisitions to drive growth. Based on my empirical data over the past year of engaging in options trading, I tend to favor covered puts.
Disclosure: The author is long Disney, Facebook, Nike, Target and Starbucks. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.
Originally published in partnership with INO.com