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## Calculating ROI When Selling Covered Calls

There has been a lot of option activity in my retirement accounts recently so I wanted to take some time and explain how to calculate the return on investment (ROI) using a real example of a trade that I did yesterday.  As you know, I am working on increasing the exposure that my portfolio has to dividend paying stocks.  Well, one of the stocks that I was looking at was Nucor (NUE).  I was able to purchase some shares using the proceeds that resulted from the exercise of ONXX \$46 puts last week.

My goal is to get a 1% return per month on my retirement account on average.  Part of this should come from the increased focus on dividends while the rest will come from capital gains and covered call premiums.  I believe that this is an achievable goal on average, although there will be times when the value will fluctuate above or below that target.

So, here is what I did yesterday.  I started by purchasing the June \$32 strike put options for \$0.49 per share.  Then I picked up the stock itself for \$34.70 and put in an order to sell the June \$35 strike calls at \$1.10.  This was about 5 cents above the ask at the time, but I figured that given the normal daily volatility, it would get filled if NUE approached \$34.90.  This did occur so at the end of the day, this is what my basis looked like before commissions:

\$34.70 for the stock + \$0.49 for the puts – \$1.10 for the calls = \$34.09

So, \$34.09 per share is the amount that I have in the stock.  Now commissions can have a big impact upon return, and I always hate it when those aren’t figured into the equation.  I keep an Excel spreadsheet and add them in automatically based upon cash in and cash of the account.  When I add in commissions for trading, my basis becomes \$34.15322 (\$34.16) per share.  This is the number I will use for the calculations, but it is a little cleaner to look at the numbers without when you are learning.

Return on Investment If Called

If NUE is at or above \$35 per share on June 16, 2012, it will get called away.  If that is the case, let’s calculate the ROI for these four weeks.  The general formula is the amount of profit divided by the amount invested (basis) multiplied by 100 to express in a percentage and would look like this:

(\$35.00 – \$34.16) (profit)/ \$34.16 (amount invested) * 100 = 2.459%

This meets my criteria of gaining 1% in a month.  But what if the stock does not increase and does not get called out?

ROI if Not Called

This is a little more difficult situation to calculate because you really don’t know if there will ultimately be any profit.  This is where the 1% monthly criteria comes into play for me.  I want the premium income itself to equal 1% of the basis.  So in this case, I use the amount of price reduction of the stock price for my “profit” and the basis as the amount invested to make the equation look like this:

\$34.70 (purchase price) – \$34.16/ \$34.16 * 100 = 1.58%

The Nucor trade meets my criteria for 1% monthly.

Capital Losses

Now what happens if the stock drops like a rock.  Obviously, these percentages mean nothing.  But this is where tracking a basis over time becomes useful.  Ultimately, if the stock drops below \$32 rapidly, I will not be in any additional danger of loss since I own the put options.  I can add additional shares to the position each time meeting the above criteria.  Eventually, the stock will stabilize and the ‘ROI if called’ will get realized.

By managing the position and adding shares at lower prices, it is possible to not lose money on a declining stock and break even.

So, if one-third of my stock picks fall into each category, the overall net impact is that the 1% monthly target will be met on a portfolio wide basis.  The fact that I am starting to work with dividend stocks should help to minimize the volatility.  That is the goal anyway.

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## GMCR–The Case for Protective Puts

You may have heard that Green Mountain Coffee Roasters stock took a big hit earlier this week when they missed earnings and put out a disappointing forcast for the remainder of the year.  In fact, the stock lost almost 48% of its value in one single trading day.  Ouch!  Now if you have been long the stock, that is a major hit to that portion of the portfolio.  Granted GMCR has been a momentum stock for some time now, so it isn’t unexpected that the gains would slow at some point.  However, it can still make for some sleepness nights knowing that one day could wipe out so much value.

Sleep Better At Night–Buy Some Protective Puts

If you are investing in the stock market (and especially in individual stocks), you need to have some plan for these events when they occur.  There are many ways to do this from not buying individual stocks and going only with indexes, to diversifying across several stocks and sectors, to using stop losses, to buying put options.  I would like to address the concept of risk management from the perspective of put options and share what I do with my retirement account.

If you have been reading this blog for a while, you know that I invest my retirement account in some individual stocks many of which might be considered risking (ironically, GMCR only shows a beta of 0.8).  Take for example, my investment in Onyx Pharmaceuticals (ONXX).  This is a stock that I bought after selling Imclone which was bought out several years back.  I purchased ONXX as a potential buyout candidate for which there is still potential.  The most recent run up is due to buyout rumors again.

Over the past year, ONXX (with a beta of 1.2) has traded from \$27.17 to \$47.80 per share.  With this most recent pop, I decided to buy some protective puts at a strike of \$46 expiring in the month of May in two weeks.  So far, that looks like a good decision since ONXX is now back down under \$43 per share.  Since my overall cost in the stock is \$43.57 even after the purchase of the puts, I have guaranteed myself a profit.

Then, I will be able to purchase back the same stock for less and either sit on the cash or purchase even more shares of ONXX in preparation for the next pop.  I will usually pay for the put options by selling some covered calls creating a collar.

I have found the technique of buying puts, selling calls or selling stock when it pops and buying back calls, exercising puts, and buying more stock to be fairly effective in mitigating losses and decreasing volatility in my retirement portfolio.

Hopefully, I won’t one day discover that the stock that I am holding has dropped by almost 50% in one day.  But if it does happen, I know that I will sleep well because I would have owned some protective puts.

Oh, and by the way, a stop loss order would not have helped with GMCR this week.  If you don’t know why, be sure to ask.

Readers:  I am guessing that most of you use indexes for your risk management, but for those who do pick individual stocks, what do you do?

Yesterday, the stock market dropped the most since November 2011.  So, what was your take?  Did it bother you that the value of your stocks dropped significantly or did you consider it an opportunity to buy stocks on sale?  Matt makes a great contrast between the attitude of declining prices when it comes to stocks versus the response to declining prices with gasoline.

I look at the fact that my investment horizon is over 25 years.  I figure that trying to pick up some shares on a down day is better for me in the long run.  I bought several shares of STX last week for \$25.82 on average when it was down over 8% in a day due to some poor guidance.  I figured that the stock pays a dividend which should help create a floor under any sort of decline.  I also figured that I could always sell some covered calls to decrease my basis if need be.

Yesterday Bought More AKS

Yesterday, I was able to purchase another 100 shares of AK Steel for \$6.95.  The plan is to sell some covered calls with the \$7 strike and a May expiration.  I put in the order today to do so at \$0.65 per share.  It hasn’t sold, but I wouldn’t be surprised if it did over the next two days before the weekend.

If it doesn’t happen and the stock ends up dropping again, I can pick up some more shares below \$7.  It is not a big deal and will lower the overall basis of the stock.  The biggest risk is that AKS has financial difficulties and stops paying a dividend or even goes bankrupt.  I don’t think that will happen over the next few months, but I do have to consider that if I increase my position too much, I will want to buy some protective puts.

I had some put options when my position was bigger.  They paid off for me as the stock slid from the teens down into single digits.  But now my overall exposure hasn’t been that large so I let the puts fall by the wayside.  I figured I would save the cost and simply work with selling calls.  However, it may be worth reconsidering if I want to purchase more shares over the next few days.

The other consideration is the fact that earnings will be coming out later this month.  That can always be a big trigger for volatility and moves one way or the other.  A big move down is bad and could hurt.  The May \$6 strike puts cost \$0.15 each.  It is probably worth it to buy some tomorrow and prepare to sell some calls as well.

Overall, the market has made a decent run over the past few months.  I am not surprised that it is time for a breather.  Summer is coming and earnings season is expected to be disappointing.  Even though yesterday was a big down day and today saw a bit of a rebound, I would probably use the down days to add to positions but only a little bit at a time.  That is what I will be doing.

So, are you buying any stocks?