Mitigating Risk, Accentuating Returns and Realizing Gains – 27.9% Return
Originally published in partnership with INO.com
I’ve written a series of articles detailing the utility of options trading and how an investor can leverage a long position in an underlying security to mitigate risk, augment returns and generate cash. This strategy comes with two alternatives in the end depending on whether or not one desires to realize gains and relinquish his shares or remain long the security of interest. I’d like to highlight Salesforce.com Inc. (NYSE:CRM) as an example for this covered call strategy. I’ll be highlighting how I’ve successfully accentuated my returns via leveraging the underlying security in the form of collecting option premiums over a 20-month span. In this example, I decided to ultimately realize gains generated from the underlying appreciation of the stock combined with the options income and relinquish my shares. Taken together, the synergy of the options income and appreciation of the underlying security generated a realized gain of 27.9% over this timeframe.
I’m utilizing a high growth technology stock that’s at the intersection of syncing the customer and enterprise relationship via social, mobile and cloud platforms. Salesforce is a contentiously debated aggressive growth stock that trades on lofty valuations. Salesforce is marginally profitable and thus difficult to assign a valuation as measured by traditional metrics such as the price-to-earnings multiple (P/E ratio) and the PEG ratio. Due to its rapid growth, expanding footprint, major partnerships with Fortune 500 companies (i.e. Home Depot, GE, Wells Fargo, Coca-Cola, etc.), expansion into international markets and its overall ubiquity in terms of its consumer relationship management (CRM) platform, it's reasonable to see why investors are willing to pay a premium. Much of its revenue is deferred as a result of its subscription-based model thus deferred revenue is often discussed on earnings calls. Deferred revenue is not yet realized revenue however it’s been received by the company. Since Salesforce delivers its service over time, this received amount isn’t reported as traditional revenue since the service hasn’t been rendered. Due to these factors and the difficulty of placing an accurate valuation on Salesforce, options in the form of covered call writing may be an effective way to leverage this growth stock while mitigating downside risk. Salesforce offers the right balance of volatility, liquidity and a high level of interest which gives rise to reasonable yielding premiums on a bi-weekly or monthly basis. This set-up bodes well for those who are long Salesforce (or a stock similar in nature) and desire to leverage options trading to augment returns and mitigate risk throughout the volatile nature of this underlying security. Salesforce’s recent string of earnings has impressed investors and covered call options may accentuate this underlying equity return. Writing covered calls in an opportunistic and/or disciplined manner may mitigate losses and smooth out drastic moves in this underlying security.
Relinquish and Walk Away or Seller’s Remorse?
Relinquishing your position is always a difficult question to address especially when one is long equity. However, taking profits and transitioning these funds into other opportunities may be prudent when large unrealized gains are available for the taking. This situation is even more relevant when one’s options income has become significant and when combined with the underlying appreciation of the stock, its profit far exceeded the current market value. This was my case with Salesforce.com, I had generated $10.99 per share or $1,099 in covered call income on top of the $8.86 per share or $886 in stock appreciation. Combined, I had an unrealized profit of $19.85 per share or $1,985 translating into a 27.9% gain. Based on these gains, I allowed my shares to be called away at $80 per share as I felt comfortable with this trade considering the shares moved from the mid $60s to the $80 level.
This is where seller’s remorse tends to creep into the equation after shares are relinquished. As these shares were called away in February of 2017, shortly thereafter the entire tech cohort caught fire and the Salesforce in particular ultimately appreciating to $92 per share. Obviously, another $12 per share in appreciation would’ve been great however combining my options income and share price appreciation I realized a 28% gain or put another way, I had effectively sold my shares at $91 per share. In this regard, I didn’t miss out on any potential gains and bought myself months of time where I was able to put this cash to work elsewhere in the market. The tech stocks have since cold off and now the shares have settled in the mid $80 range. I can live with a 27.9% combined gain and deploying that cash into other opportunities than remain in a stock that’s richly valued based on its P/E ratio and non-GAAP earnings, which always concerned me. The lesson from my experience is no one can time the market and the tech run-up was a surprise to me. However one can effectively mitigate risk, accentuate returns and realize gains leveraging options as demonstrated in this article.
52-Week Narrow Trading Range
Salesforce has maintained a fairly narrow trading range throughout the past two and a half years with the exception of a major correction in February of 2016. This trading range has largely been confined to the $65-$80 range with a 52-week high of $92 as a result of the recent strength in technology (Figure 1). This narrow trading range for a relatively volatile stock can bode well for options traders.
Figure 1 – Two and a half year trading range of Salesforce
Riding the uptrend waves to the higher end of the multi-year range (prior to the tech rally in May of 2017) while writing covered calls one can extract additional value in a long position. Tables 1 and 2 provide the details of each option contact. The majority of these options were sold in a “disciplined” manner, typically over longer time durations with a strike price that falls far out-of-the-money (~7% higher than the current price). I’ve also engaged in “opportunistic” options where a rare scenario in which the underlying security skyrockets high-single digits or low double-digits in a single session or over the course of two to three trading days. This typically occurs over after an earnings beat and raise in guidance.
Table 1 - Original purchase price $71.14 along with subsequent options contracts
As detailed in Table 1, I’ve been able to extract an additional 15.4% in the form of options premiums while the appreciation of the underlying security has an unrealized gain of 12.5%. Taken together, the synergy of the options income and appreciation of the underlying security has yielded 27.9% over the course of roughly 20 months.
Table 2 – Simplified table of the options contacts on Salesforce stock
Opportunistic Spikes and Writing Covered Calls into Earnings
During the week of October 20th, 2015, on the heels of very robust earnings from Microsoft, Amazon, and Alphabet (Google) the entire tech sector benefited and stocks such as Salesforce witnessed a strong uptrend as a result. I wanted to capitalize on this uptrend as Salesforce broke through its 52-week high at the time. For this options trade, I targeted a soft 10% upside buffer factored into the strike price. For my Salesforce position, a 9% upside was built into the strike price ($85 strike - $78 at option) and factoring in the premium I arrived at a 10% upside buffer. This upside buffer was particularly important as earnings were underway. Salesforce reported earnings on 18NOV15 and handily beat estimates and the stock jumped 5% the next day and touched $83 per share. In this case, for a long position, this 10% buffer was necessary in order to remain in the position while extracting value via far out-of-the-money covered call option writing while factoring in the potential upside as witnessed after the conference call and with the overall uptrend in the stock.
In April/May 2016, Salesforce was stuck in a tight trading range between $74 and $77 per share. I decided to write a covered call when the stock reached $74 per share with a strike at $80 per share with an expiration date of 05/20/2016. Salesforce was due to report earnings on 05/18/2016 just prior to the expiration of this contact. I wrote the option at risk knowing that if the earnings report turned out to be positive, the stock would likely rise higher than the strike of $80. Due to the overall upside of ~9.4% (appreciation in the strike plus the premium yield), I would be effectively paid $81.15 per share if relinquished. However, I was writing this option at risk due to the increased uncertainty surrounding the upcoming earnings report. The earnings report would either move the stock up or down in a dramatic move. I wanted insurance in the event the report turned out to be negative and unfortunately for me this strategy didn’t work out too well (Tables 1 and 2) and I had to buy back the option at a loss in order to avoid relinquishment at this stage in my stock holding period.
Salesforce is a highly debated stock and isn’t intended for value investors. Salesforce has been growing at a double-digit clip on an annualized basis, and this impressive growth will likely continue in the near-to-intermediate term as cloud-based analytics are the future to any enterprise business more specifically in the CRM space, not to mention the highly acquisitive nature of Salesforce. In the meantime, as a long investor, writing covered calls in opportunistic scenarios may mitigate these drastic swings in the stock price while generating income and potentially realizing gains. This is especially true given Salesforce’s recent string of earnings strength and underscores the value of covered call writing to mitigate potential downside swings and smooth out drastic moves in this underlying security. Taken together, options income may greatly augment overall returns and in the example provided in this article, I’ve been able to realize a 28% gain and reallocate these profits into other opportunities as detailed above.
Disclosure: The author does not currently hold shares of Salesforce and the author does not have any plans on initiating a position in Salesforce. 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.