On November 12, 2014 the SPY, the exchange-traded fund that tracks the Standard & Poor’s 500, closed at $203.96, near yesterday’s closing all-time high.
That was good news for anyone who owned stocks. Almost everyone who had a stock position had a profit on it. But whenever new highs are made, the question becomes whether, when, and how to take profits on long-term positions. Enthusiastic buyers are transformed into nervous potential sellers.
The default action would be simply to hold the stock position and continue to gain more profit as it goes higher still. This is great if stocks do go higher, and not so great if they don’t. Let’s look at some alternatives that involve the use of options. We could, for example:
A. Keep the stock position and sell call options to collect premium that will cushion some downside movement.
B. Keep the stock and buy put options as insurance.
C. Combine the above two alternatives: Keep the stock, sell call options, and use the money from the call sales to buy put options as insurance.
D. Sell the stock position. Determine at what price we would be willing to buy back in, and sell put options at that strike price.
E. Sell the stock position and bank the profits. Use a portion of the cash to buy call options, to participate in further upside movement. Other bullish option strategies could also be used in place of the long calls.>
First, consider choice A, the Covered Call. Today we could have sold December 208 call options on SPY for $1.07 per share. For each hundred shares that we owned, we could have brought in $107. The calls expire on Friday, December 19, 37 days from now. The calculation of potential profit or loss is as follows:
If SPY is at or below the $208 strike price at expiration (December 19), the calls will expire with no value. Our profit/loss per share on the SPY will be improved by the $1.07 call premium received. This $1.07 on our $ 203.96 initial position value amounts to .52% in 37 days. Annualizing this, the extra return from the call sale amounts to an annual rate of 5.17%. This is in addition to whatever else we might make or lose on the stock price movement.
If SPY is at any price above the $208 strike price at expiration, the calls will be assigned. This means we will be forced to give up the SPY stock and accept $208 per share in payment. This happens automatically. In that case the SPY shares will be plucked out of our brokerage account, and $208 per share in cash will be put in. Our total proceeds per share will then be that $208, plus the $1.07 per share we received for the call, for a total of $209.07. Compared to the current price of $203.96, that will represent a profit of $5.11 per share in 37 days. That would work out to an annual percentage rate of 24.17%.
(The above calculations do not include any effect from a dividend of about a dollar per share that SPY will pay to whoever owns it as of the close of business on December 18. We would expect SPY to drop in price overnight on December 18/19 by the amount of the dividend, washing out its effect.)
The only case in which selling the calls on SPY would not improve our profit, would be if SPY were to end up on December at a higher price than $209.07. Having sold the call option, that amount would be the most we could ever realize out of this position, no matter how much higher SPY might go.
The pros and cons of this position are as follows:
- The $1.07 call premium provides a cushion of that amount in case of a drop in SPY.
- Our profit is improved by $1.07 at any SPY price below $208. This is 5.1% APR extra profit.
- We will own the SPY shares on the ex-dividend date and will receive the dividend.
- The $1.07 call premium is all the cushion we have. We are still exposed to any drop in SPY that is larger than that.
- Our upside profit is no longer unlimited. If SPY should rise higher than $209.07, our profit will be less than it would have been had we just kept the stock and not sold the call.
Taking these factors into account, we would consider this to be a good trade if we were neutral-to-moderately-bullish on SPY. If we were wildly bullish, we would not limit our upside by selling the calls. And if we were bearish, we should choose another alternative – the obvious one being to sell the stock and take our profits.
In Online Trading Academy’s Proactive Investor program, we use the covered call strategy heavily. When the call strike prices are chosen so as to be just out of range of the expected movement in the stock, it is a very effective tool for adding incremental profit to a portfolio. When choosing strike prices that are higher than the current stock price as in this example, the covered call gives us three separate potential sources of profit:
- Profit on the stock itself, although limited to the gain from the current price to the strike price
- Dividends that are paid on the stock while we own it
- Premium received from the sale of the calls
The last of these, the call premium, is icing on the cake, adding to the other benefits of owning the stock itself.
Next time, we’ll compare the covered call strategy to more of the alternative strategies for combining additional profit with protection for our stock positions.
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