We have written several articles about how options can be used as a strategic investing tool. We have mainly focused two simple option strategies:
- Covered calls as a way of increasing cash flow on a stock or ETF position
- Cash-secured puts as a way of acquiring a desired stock at a discounted price.
Each of those strategies can also be used in a different way, with just a slight modification, that can be very useful to an investor.
First, the covered call.
A common way of employing this technique is as follows: You buy (or already own) shares of a stock or ETF. You then identify a higher target price, at which you would be happy to sell your shares for a profit. You then sell a call option with a strike price near the target. If the stock does go past your target/strike price (and stays above it at the option expiration date), you will give up your stock and be paid a price equal to the strike price of the calls. This was your target, and you would have sold there anyway, so all is good; and as a bonus, you get to keep the money you were paid for the call. This is gravy on top of your stock profit.
Before we tackle the alternative use, let’s look at an example of the above-described covered call.
Below is a daily chart of XLV, the health-care exchange-traded fund. Let’s say that we own 100 shares. We have had a nice run on this for the last few weeks, and it is now approaching a target at around $92, at which price we would be happy to sell.
Standard Procedure: The Out-of-the-Money Covered Call
At this time, the price of XLV was $90.69. The February options, with 14 days until expiration, included call options at the $92 strike price, which could be sold for $.49 per share ($49 per contract, each contract including 100 shares).
If we now sell one of those calls, $49 is deposited in our brokerage account immediately. We are now obligated to give up the shares, in exchange for an additional payment of $9,200 for the 100 shares, when and if the call buyer (remember, we are the call seller) decides to exercise the call.
No call buyer will exercise a $92.00 option unless the stock price is higher than $92.00 at the time. So, if XLV stalls here at $90.69 and does not move higher in the next 14 days, we will not have to give up the stock; but we will still get to keep the $49 call premium. In this case, we have received a $49 return (the call premium) on a $9,069 investment (current value of the stock, which is now tied up pending the option expiration). Over a 14-day period, our annualized return would be:
(Return / Investment) X (365 days per year / number of days the investment was held). In this case that would be:
($49.00 / $9069) X (365 / 14) = 14.08%
We’re happy with this return. Of course, if XLV does go higher than it is now by the February expiration, our profits will be larger. We have room to make some additional profit on the stock, on top of the call premium. At maximum, our profit on the stock counting from here could be an additional $131, which is the $92.00 strike price at which we must sell, less the current value of $90.69, times 100 shares: ($92.00 – $90.69) * 100 = $131.
This would more than triple the 14.08% return from the option alone and is our best-case scenario.
Even if the stock goes down a bit, we now have a $49 cushion against loss because we took in that much as the call premium.
Very good. Covered calls are a popular strategy and for good reason, in a neutral to bullish market environment they work very well when specific trading rules are followed. Now let’s look at this a little differently.
Modified Procedure: The In-the-Money Covered Call
Let’s stick with the XLV example, but let’s say that we are of a more conservative bent. We would like to lock in the profit that we have now, noticing that XLV just surpassed a recent swing high of $90.13 which we had had our eye on as a target. But we would be happy to squeeze a little more money out of the position if we could. Selling covered calls in a slightly different way can help us do that.
On this same day, February call options at the strike price of $88.50 could be sold for $2.72 per share or $272 for the contract. Because the $88.50 strike price is lower than the current stock price, these options are said to be in the money. If we sold these options, we would receive $272 today. We would then be obligated to give up the stock in exchange for an additional $8,850 (total proceeds $272 + $8,850 = $9,122) if XLV remained anywhere above $88.50 at the February expiration (or possibly earlier if an option buyer decided to exercise early, which would be even better for us).
The total proceeds of $9,122 is more than the $9,069 that we would receive today if we simply sold the shares outright, by $53. So, compared to simply selling the shares today at $90.69, selling the covered call and then giving up the shares later would increase any profit we already have in the stock by an additional $53. Using the same sort of calculation as before, this additional $53 on our $9,069 tied up gives an additional 15.23% (annualized) on top of whatever existing stock profit we may have.
That $53 of extra profit will be the outcome in this case, as long as we do in fact collect the $8,850 for the stock. That will happen if XLV is anywhere above the strike price of $88.50 at expiration in 14 days. What if it isn’t? That could happen. In this case there’s statistically about a 25% chance of that.
Because we have pocketed $2.72 per share today for the calls, our break-even-from-current price level has dropped by $272, to $87.97. We will now make more money than the profit we already have if XLV remains anywhere above $87.97 at the expiration in 14 days. This was very likely.
In any case where the stock is below the $88.50 strike at expiration, we will not give up the stock or get paid the $8,850 for it; we will still own the stock. We will also still own the $272 in cash that we received for the 88.50 call, reducing our cost basis in the stock by $2.72 per share.
The worst case in this scenario is that XLV was under $87.97 in 14 days. In that case we would be worse off than we would have been had we sold the stock immediately. If we liked, we could plan to exit the trade when and if XLV approached that level to limit our potential losses. Or we could plan just to keep the stock and sell more in-the-money calls until we eventually are relieved of it.
The in-the-money covered call can be a good way to sell appreciated stock at an even higher profit, or in the worst case to reduce our break-even price of the stock. Consider adding it to your toolbox.
Next time, we’ll look at an alternative way to use the cash-secured short put.