the eventof exercise.The disadvantage to selling covered calls is that you tie up 100 shares foreach call sold, and you cannot escape from the covered position withChapter 5 Options as Cash Generators
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out closing out that short call. For example, if you sell a call and receivepayment (the premium), and you later decide you do not want to continue in that position, you have to buy the call to close. (Remember, theinitial transaction was a sale; to close that out, you next need to buy thecall with a closing purchase transaction.)You should close the position under one of two circumstances. First, ifthe value of the short call has declined since the time the position wasopened, you can pay the current price and close out the position. The netdifference (the original sales price minus the closing purchase price, netof trading expense) will be a capital gain, which is taxable in the year theposition is closed. Second, you should close the position if the value ofstock has moved upward beyond the strike price. In this situation, youface the possibility of exercise, which can happen at any time when thecall is in the money (current market price of stock is higher than thestrike price of the call). When the stock’s price moves above strike price,the net premium value of the short call may be lower than it was whenyou sold it. This is true because the call’s time value declines as exercisedate comes closer. In this situation, it is prudent to buy and avoid exercisewhile still realizing a net gain on the call transaction. Incidentally, onceyou close out the covered call position, you are free to repeat the transaction, using calls with higher strike prices and later expiration dates.If the stock’s price moves above strike price so that your short call is inthe money, the call’s value may also have increased. You can still avoidexercise without taking a net loss, using a technique called rolling(replacement of one call with another). This strategy is explained indetail later in this chapter.
Examples: Ten Stocks and Covered CallsTo illustrate how the basic covered call strategy works, we examine the10 companies in our model portfolio, sharing three common attributes:1. Both listed options and long-term options (LEAPS) are available on the stocks.2. All of these stocks are assumed to have current market valueabove the original basis. (There is no justification for engaging
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
in covered calls for stocks whose market value is lower than thebasis; the conservative strategy works only when the stocks haveappreciated in value since the time of purchase.)3. All stocks show current moderate price volatility levels. (If volatility in a stock is high, so is market risk; if it is too low, option premiums also are low, and the strategy may not be justified.)These stocks’ attributes are summarized in Table 5–1.Table 5–1 Sample Stocks for Covered Calls
Name of company
Symbol
Current Price*
DividendYield
Clorox
CLX
$55.91
1.9%
Coca-Cola
KO
38.90
2.6
Exxon Mobil
XOM
48.70
2.2
Fannie Mae
FNM
67.65
3.1
Federal Express
FDX
87.78
0.3
General Dynamics
GD
100.01
1.4
J.C. Penney
JCP
38.20
1.3
Pepsico
PEP
48.48
1.9
Washington Mutual
WM
38.43
4.7
Xerox
XRX
14.32
1.4
* Values shown reflect closing prices, October 22, 2004.
Working within Pre-Established StandardsThe covered call strategy works at specific strike price levels, so we proceed on the premise that stocks you own share all of these attributes aswell. If they do not, the covered call strategy will not conform to yourconservative standards. The first step is to select strike prices that are(a) at or out of the money and (b) higher than your original basis inthe stock.
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In Table 5–1, note that Washington Mutual reports the highest dividendyield of 4.7 percent. Because we base our conservative covered call strategy on stock attributes, the high current yield is attractive; while we maynot consider dividend yield for stocks currently owned, the yield mayaffect the decision to purchase particular company stock given that fundamental indicators are otherwise equal. If you owned all 10 of thesestocks in your portfolio, you would expect to also experience a varyingrange of potential profits from covered call strategies. By the same logic,you might also own other stocks whose option premiums would notmeet your expectations. Referring again to Table 5–1, you may decide toavoid writing covered calls of Washington Mutual specifically because ofthe high dividend yield. It may be preferable to ensure that you retainthese high-yielding shares and reserve covered call writing for the lowestyielding stocks on the list, notably Federal Express (yielding only 0.3%),J.C. Penney (1.3%), General Dynamics (1.4%), or Xerox (1.4%).We next analyze a series of options in comparative form. If you compare options with different expiration terms, you should annualize thereturn. In our case, we use LEAPS calls, all of which expire in 27months. A summary of call option values expiring in 27 months isshown in Table 5–2.
Calculating the Gain ComparativelyLet’s review how these values must be read. In the case of the Pepsioptions, we see that the 27-month option with strike price of 40 is currently worth 5.70 ($570). So, if you sold this option today, you wouldreceive $570 (minus trading fees) as premium for the sale.If you sold the 50 option (one having a strike price of $50 per share), youwould be paid 2.30 ($230) per option. We can perform a very fast returncalculation based on the difference between today’s value and strike priceto see what you would gain if each call were exercised. Upon exercise,your 100 shares of stock would be called away at the strike price: in thefirst instance, $50 per share, and in the second, $55 per share. The following calculations are based on today’s price, however, and not on whatyou actually paid for the stock. Based on the current price, if the short call
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Table 5–2 Covered Call Premiums, 27 Months Until Expiration
Name ofCompany
Symbol
CurrentPrice
27-MonthStrike
Call OptionsPremium
Clorox
CLX
$ 55.91
Coca-Cola
KO
$ 38.90
Exxon Mobil
XOM
$ 48.70
Fannie Mae
FNM
$ 67.65
FederalExpress
FDX
$ 87.78
GeneralDynamics
GD
$100.01
J.C. Penney
JCP
38.20
Pepsico
PEP
48.48
WashingtonMutual
WM
$38.43
Xerox
XRX
14.32
55607040455050556070809090951001001101204050605055604045501517.5020
$ 7.305.102.30$ 4.002.151.15$ 4.502.701.60$ 8.304.802.45$12.3010.108.10$13.909.606.40$ 5.702.501.00$ 4.302.301.15$ 3.101.650.80$ 2.551.600.90
Closing prices as of October 22, 2004, and option bid values for January 2007calls as of closing on October 22, 2004.
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were exercised in the month of expiration, you would gain (excludingdividend income and not allowing for taxes) the following:
07 JAN 50January 2007 expiration;strike price 50Sale of stock
$5,000
Less current value
–4,848
Stock profit
$ 152
Return
3.1%
Call premium
430
Option yield
8.9%*
07 JAN 55January 2007 expiration;strike price 55Sale of stock
$5,500
Less current value
–4,848
Stock profit
$ 652
Return
13.4%
Call premium
230
Option yield
4.7%**
* $430 ÷ $4,848 = 8.9%** $230 ÷ $4,848 = 4.7%
We show the stock and option profits to make an important point: whileyou do not include the stock’s capital gain as a means for picking onecovered call over another, the return if exercised varies based on strikeprice. In this example, the lower strike price of 50 produces a higheroption gain but lower stock capital gain, and the higher strike price of 55produces a lower option gain but a greater capital gain. The 50 strike
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
price example produces a 12.0 percent overall gain, and the 55 strikeprice produces an 18.1 percent overall gain. So, while you should notmix the two potential outcomes, the selection of one strike price overanother is essential if you expect to make valid outcomes based on various scenarios. In the example, the higher strike price produces a moredesirable outcome, even though the option premium return is lower.If we annualize1 these rates of return—again, based only on stock saleand option premium—we must adjust the reported gain to show theyield based on a 12-month holding period:
07 JAN 50January 2007 expiration;strike price 50Stock gain
(3.1% ÷ 27)
12 = 1.4%
Option premium
(8.9% ÷ 27)
12 = 4.0%
Stock gain
(13.4% ÷ 27)
12 = 6.0%
Option premium
(4.7% ÷ 27)
12 = 2.1%
07 JAN 55January 2007 expiration;strike price 55
This example demonstrates that in comparing two different options, wearrive at a rate of return based on stock gains and another separatereturn based on option premium. We do not want to combine thesebecause it remains important to compare option outcomes if exercisedand if expired, excluding any capital gains on stock. The point relatesonly to the selection of strike price based on various exercise outcomesand demonstrates that overall returns are substantially different whenstock profits are also considered.
1 Annualizing option returns is important because holding periods are likely to vary from a fewweeks or months to several years. The basic annualization formula involves dividing theyield by the holding period (in months) and then multiplying the result by 12 (month);this produces the average annual yield.
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As we observed before, this is a brief overview and is used only for comparative analysis. Actual comparisons should be based on your purchase price of stock, include a calculation of dividend income, andconsider the overall tax liability as part of the calculation. More on taxation of covered call exercise is found later in this chapter.
Smart Conservative Ground RulesAll strategies have positive as well as negative aspects. The covered callstrategy is conservative, assuming that you understand the transaction’s specific attributes and that you are sure the numbers work inyour favor. We must observe seven basic ground rules as we proceedthrough the analysis to ensure a truly conservative application of thecovered call strategy:1. Your original purchase price has to justify the strategy. The mostconservative use of covered calls is found when you own stockthat has appreciated in value. The lower your basis in comparison to today’s market value of stock, the more flexibility youhave in devising a conservative options strategy. In fact, the useof covered calls is a sensible way to protect a portion of yourpaper profits without needing to take those profits. For example, if you have a 30-point paper profit, selling a covered calland receiving a premium of 10 ($1,000) gives you 10 points ofdownside protection, or one-third of your total unrealizedprofit. If you sell a series of covered calls over time, it is evenpossible to take all of your profits out of the position withoutselling stock. For example, if you received a premium of 10 onthree subsequent calls over a period of many months, with eachone expiring and being replaced in turn, the entire 30 points ofpaper profits can be taken as capital gains.2. The premium value you will receive has to provide enough yield tojustify the covered call exposure. If you plan to use your stock ascover for a short option position, you must be able to justify itin terms of profit levels. Check returns from option premiumon an annualized basis. So, if you own shares of many different
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OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
stocks, you will naturally seek out those option positions thatyield the best returns. In comparing one option position toanother, be aware of the rate of return and the time until expiration. A 5 percent return you earn in 6 months is far more profitable than a 10 percent return that takes 24 months. Alsoremember that you will not always keep the short position openall the way until expiration. You can close out short positions atany time. For example, one very profitable strategy is to sell acovered call, wait for the time value to decline, and then enter abuy-to-close order, realizing the net difference as a profit. Afterthe position is closed, you can open another covered call usingthe same stock, but with more time value and profit potential.3. You are willing to accept exercise as one of the possible outcomes. Inevery covered call position, you have to accept the possibility thatyour 100 shares of stock will be called away. In fact, someinvestors are drawn to options with the original idea of acceptingexercise and selling shares, only to realize that repetitive coveredcall selling may be more profitable. If you do not want exerciseunder any circumstances, you should not write covered calls.However, for many investors, covered call writing is a smart alternative to simply selling shares. Keeping shares of stock and theassociated dividend income and selling calls to realize short-termprofits is one effective way to achieve current returns.The idea that you must be willing to accept exercise is not a problem if,in fact, exercise produces capital gains in addition to option returns.The risk in such a transaction is that the covered call could be exercisedand you would be required to sell your 100 shares of stock. But a riskthat comes with a return is one that most investors gladly accept—assuming that it is structured to produce profits if and when the shortcall is exercised.1. You are aware of the tax consequences in the event of exercise. Ifyou trade in options without considering the effect on yourstock positions, taxation is easy to understand. If you sell a calland it expires worthless, your gain is treated as short-termregardless of how long it was held. So, tax treatment of LEAPSoptions is different than for most other investments.
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(Incidentally, less conservative investors who go long on optionsmay have either short- or long-term gains or losses, dependingon the usual holding period rules.) However, for covered calls,the tax rules are very complex, as explained later in this chapter.For now, the point is that you must understand how capitalgains rules apply to a particular strategy and consider the taxconsequences as part of your overall return calculation.2. The primary risk to the covered call strategy is possible loss offuture market gains if and when stock prices exceed the call’sstrike price. This lost opportunity risk should be understoodbefore you enter into any covered call strategy.Example: You purchased stock at $35 per share. Today, it isvalued at $40. You sell a covered call expiring in 1 year andreceive a premium of $300. The strike price is $45 per share. Ifthe stock rises above $45, your stock will be called away. At thetime you enter the transaction, you justify the decision basedon your purchase price, which is $10 per share below thestrike price. Furthermore, strike price is 5 points higher thantoday’s stock value, so the entire premium represents timevalue. Finally, the $300 premium is extra income equal to 8.6percent of your original purchase price. This analysis makessense; however, let’s say the stock’s market value soars to $60per share and your stock is called away at the strike price of$45 per share. Your lost opportunity cost for this transactionis $1,200, the difference between market value of stock andstrike price of the call.In this example, the lost opportunity arises from the stock’smarket value climbing 15 points above the call’s strike price. Inthe analysis of a covered call strategy, you have two risk factorsto consider. You know (given the example) that you can createconsistent high returns with no increase in market risk. Youalso know that for stocks you own that have appreciated invalue since you purchased shares, this scenario can be repeatedmany times unless a particular call is exercised. In exchange forconsistent high returns, you must look at the other side: in
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some cases, a stock’s market value rises above strike price, andyou may lose the potential profits had you not entered into thecovered call strategy. That is the lost opportunity.Here is the essential question: Are you willing to give up theconsistent higher-than-average returns on all stocks on whichyou can write covered calls in exchange for the lost opportunitythat might occur? You need to assess lost opportunity risk inthe context of your conservative portfolio, considering yourwillingness to accept possible exercise, dividend yield comparisons between stocks, proximity of striking prices to currentmarket value, and the amount of profit in the current positionbased on original purchase price. The stocks you own todayshould have a good chance of growing in market value gradually over time. Lost opportunity risk cannot be ignored; but thatrisk may be less significant in the conservative portfolio.Lost opportunity risk can be mitigated using a secondary covered call strategy, rolling forward and up, discussed later in thischapter. The point here is that even though stock prices mayrise more quickly than you expect in some cases, the lostopportunity risk is not absolute. You can (a) close option positions to avoid lost opportunity risk; (b) avoid risk by employing covered calls on only a portion of your holdings (forexample, covering 100 shares when you own 500 shares, so only20 percent of your holdings in a particular stock are evenexposed to the lost opportunity risk); and (c) employ rollingtechniques to escape the lost opportunity risk or to mitigate thefuture lost opportunity you might experience when stock pricesrise even further.Lost opportunity is a “delightful problem” for conservativeinvestors. It is an opportunity to accept exercise at ensuredhigh-yield levels; it allows you to roll out of one position andreplace it with another to increase profits even more; and if youhave employed covered calls on only a portion of your holdings, it means the balance of shares on that company continueto appreciate in value. Many investors would be quite pleased toface a lost opportunity under these circumstances.
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3. The covered call strategy commits the capital invested in stock foras long as the short call remains open. Because a conservativestrategy requires that your long stock position is maintained asan offset to the short call, your shares are committed until theshort position is closed. You escape this commitment when youbuy to close the call, when the call is exercised, or when the callexpires. If you plan to keep the covered call position open untilexpiration many months in the future, for example, this meansthat you cannot sell shares until the call is closed or canceled.(You can sell shares, of course, but that would transform thehighly conservative covered call strategy into a high-risk uncovered call strategy.)Is it worthwhile to keep shares committed? As a conservativeinvestor, a basic assumption made here is that you own sharesof a particular company as a long-term investment and wouldnot want to sell. The alternative to the covered calls strategy isto take no action, but simply to continue your hold strategy inthe stock. Covered call writing does not change this basic strategy; it only employs the stock to enhance profits via option premium. So, yes, assuming your portfolio strategy does notchange, it is worthwhile to keep shares committed.A second point to remember is that even though your sharesare committed or tied up relative to the short call, you will continue receiving dividends as long as you own your shares. So, ifpart of your conservative strategy is to invest in high-yieldingstocks, the covered call does not change this strategy. If you arealso using a dividend reinvestment program to achieve compound returns on your dividend income, this will also continueto occur. So, remaining committed to keeping the stock is consistent with your existing conservative strategy.4. Most important of all, your primary portfolio strategy has toremain the same, seeking long-term investment in the stockof properly selected companies, not in selecting stocks basedonly on potential covered call returns. One danger in usingoptions to enhance profits is that it could change your entire
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investment strategy. As a conservative investor, your firstrule should be that, no matter what, the proper selection ofcompanies based on fundamental strength and growthprospects must remain the primary means of stock selectionand the primary deciding factor for any decision to buy,hold or sell shares.Example: You have built a strong portfolio of stocks withgrowing dividend payment history and with a consistentlong-term growth record. However, in looking through theoptions listings, you discover that some other stocks haveoptions yielding much higher premium levels than yourstocks. You sell your holdings and replace them with stocks onwhich higher yields can be achieved with covered call writing.This is a big mistake. One essential rule in the options marketis that higher risk stocks (defined by the primary market riskfactor—volatility) exhibit a correspondingly higher volatilityin option time value premium. As a consequence, if you concentrate on stock selection with option premium as your primary criterion, then you will be replacing a conservativeportfolio with a high-risk portfolio.
A Conservative ApproachProceeding from the ground rules for covered call writing, the nextstep is to determine exactly what makes elements of the strategyadvantageous. As a conservative investor, what are the primary attributes you need to enter a profitable conservative strategy? There arethree: appreciated value in the stock, time value premium, and downside protection.Element 1: Appreciated value in the stock. As long as the current valueis higher than your basis, you have great profit flexibility in entering acovered call strategy. By this, we mean that with those paper profits, youcan build in a greater certainty of profits. For example, consider howdifferent the return scenario looks in the two following examples:
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Example 1: Covered calls without substantial appreciatedvalue in the stock. You purchased Exxon Mobil stock at $46per share; today, shares are worth $48.70. You sell a January2006 (15-month) $50 strike call and receive a premium of$4.40. If exercised, total return on stock and on option transactions (without adjusting for trading costs, annualization, ortaxes) would beCapital gain, $5,000 strike price less $4,600 basis = $400Capital gain = 8.7% (before annualizing)Option premium = $440Option return = $440, or 9.0% ($440 ÷ $4,870)Example 2: Covered calls with substantial appreciated valuein the stock. You purchased Exxon Mobil stock at $36 pershare; today, shares are worth $48.70. You sell a January 2006call with a strike price of $50 and receive a premium of $4.40.If exercised, total return on stock and on option transactions(without adjusting for trading costs, annualization, or taxes)would beCapital gain, $5,000 strike price less $3,600 basis = $1,400Capital gain = 38.9% (before annualizing)Option premium = $440Option return = $440, or 9.0% ($440 ÷ $4,870)Clearly, the greater appreciation from higher capital gains enhances theoverall return from combined capital gains and option premium. Theconservative covered call strategy requires that the scenario producesuch returns if the call were exercised. However, it is also important toremember that in comparing option-specific outcomes, we do not consider the capital gain as a part of the total return. The example aboveillustrates that exercise produces higher profits for appreciated stock
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than for stock that has not appreciated. It simply makes the point thatyou should prefer to use appreciated stock in covered call strategies.Exercise is one of the possible outcomes, and we cannot just ignore thepotential capital gain. That may even be desirable. However, the majorityof covered call writers would prefer to gain option profits without goingthrough exercise so that they can repeat the strategy many times. You canavoid exercise in a number of ways; however, if you look at exercise as aworst-case outcome, then you will want to ensure before entering theposition that it is justified by the level of profitability upon exercise.Element 2: Time value premium. The key to successful covered callwriting is in the time value premium. To review, every option’s premium contains two parts. Intrinsic value is the value of in-the-moneypoints. For example, if strike price of the call is $40 and the currentmarket value of stock is $43, the call contains 3 points of intrinsic value.Time value is any premium above intrinsic value. If the call is at themoney or out of the money, there is no intrinsic value. For example, ifthe stock is valued today at $43 and the 40 call premium value is 5($500), it contains 3 points of intrinsic value and 2 points of time value.If the stock value is at or below $40 per share, a call with a 40 strikeprice consists entirely of time value premium.Time works for the seller and against the buyer. Buying options can behighly speculative because the buyer has to hope not only that the stockrises enough to create intrinsic value prior to expiration but that thegrowth in price also rises far enough to offset lost time value. Becausetime value evaporates as expiration approaches, this is very difficult toachieve. For example, a buyer may purchase a 40 call and pay $500 (5points) when the stock is valued at $39 per share. In this situation, thepremium is all time value. That stock must rise to at least $45 per sharejust to break even by expiration. (The buyer paid 5 points for timevalue.) Even before considering the cost of trading on both sides of thetransaction, the buyer must experience considerable growth in thestock’s market value to create a profit.In comparison, time value from the seller’s point of view is an advantage.Knowing that time value declines no matter how the stock’s price movesby expiration, the time value premium is a cushion. In the circumstances
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described above, imagine the advantage the seller enjoys even when thestock’s market value rises. For example, let’s say the seller sells the $40 callat 5 when the stock is at $39 per share. By expiration, the stock is at $43.This is not enough for the buyer to profit; the 3 points of intrinsic valueare still 2 points lower than the premium the buyer paid. However, theseller has a different point of view. As expiration approaches, the concernis that the call will be exercised for the 3 points in the money. The sellercan close the position by buying the call to close. Before considering trading costs, the profit is $200. The call was sold for $500 and then purchased for $300. The seller makes a profit, whereas the buyer cannot inthe same circumstances. (Sellers can also roll out of this position; moreon this later in the chapter.)With traditional listed options, the lifespan is generally as short as 8months. While time value is an important part of the seller’s equation,greater time value profit potential is found in the LEAPS calls. TheLEAPS option has a life span up to 36 months, so option time value issubstantially higher. For example, a comparison of various options onFederal Express calls with stock at $87.78 and strike price at 90 (basedon closing prices, October 22, 2004, when stock was valued at $87.78per share) demonstrates the point:
Expiration Month
OptionValue
Return
AnnualizedReturn
January 2007
$12.30
14.0%
6.2%
January 2006
$ 8.20
9.3
7.4
January 2005
$ 2.50
2.8
11.2
November 2004
$ 0.85
1.0
12.0
This example shows that the longer period produces a higher yield intime value premium. In the example above, we are dealing strictly withtime value. The stock’s price is below the $90-per-share strike pricelevel, so all premium is time value for the 90 call. The longer you arewilling to keep your long stock positions exposed with a short callcover, the greater the time value premium; but as the example also
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shows, the yield on an annualized basis tends to be higher for shorterterm options.Element 3: Downside protection. Every investor whose stock hasappreciated in value worries about losing the paper profits, so profittaking is more likely as paper profits increase. Well-disciplined conservative strategy tells us that we should not give in to the temptation tospeculate on short-term price movements, that is, by taking profits.However, as the old adage tells us, “Wall Street climbs a wall of worry.”Selling covered calls against appreciated stocks is one way to offset yourpersonal wall of worry. The premium you receive from selling coveredcalls is, in a sense, a way of taking profits without giving up ownershipof shares. Those profits are yours to keep in the event of expiration orexercise; and if you close the position by buying the short call, the difference between sell and buy price represents profit or loss. In any ofthese events, you continue owning stock and receiving dividends.The net premium you earn from selling calls can be viewed in anotherway: as downside protection. For example, if your original basis instock is $40.00 per share and you sell a call for a premium of 4 ($400),that is a 10 percent reduction in your basis. Your adjusted basis in stockis $36 per share, not $40. Viewing covered calls in this way, you achievea broader range of profit margin, meaning more downside protection.The more premium you receive from selling calls over time, the higheryour downside protection.
Tax Ramifications of Covered CallsCalculating returns without also figuring out the after-tax outcome isnot realistic. Not only must you consider a tax liability, you also need tobe aware that the tax rules can drastically affect your tax rate on capitalgains. The current rules for federal taxes on option trades are morecomplex than for most forms of investing. For conservative investors, acrucial point to remember is that selling out-of-the-money calls is theleast complicated strategy, for two reasons. First, the entire premiumconsists of time value. Second, the tax rules are simple as long as yourestrict your trades to out-of-the-money positions so there is no effect
Chapter 