There are a lot of bloggers in the personal finance realm who are passionate about passive income and dividends. This post is primarily directed at them but also to anyone else who might be looking toward investing in stocks in the future. Take this information and tuck it away. It may be very valuable someday and help you achieve your passive income goals much more quickly.
Learning With an Example
For those who may not be especially familiar with options, I always find it more instructive to use a real life example. The numbers that I am using are from July 13th, 2011.
One of the stocks that I have read about repeatedly on the dividend blogs is Intel (INTC) so I will use that stock as an example. When I look at the price of INTC, I find that I could purchase 1000 shares for $22.60 per share which would cost $22,600 plus some nominal commission using an online broker.
Now most dividend investors would be content to earn a 3.7% dividend yield on this stock. There is nothing wrong with that by any means. But what if I told you it were possible to nearly triple that return? Would you be interested? Let me share how that could work.
When I look at INTC stock over the past 3 years, I find that it really hasn’t traded above $25 per share. It was much lower than its current price in early 2009 in the midst of the financial crisis, but I think it would be safe to say that it is unlikely to trade above $25 unless we see a huge rally. Even with the DOW at record prices in 2007, INTC spent little time above $25. The odds are certainly favorable that $25 is major resistance. Personally I would be happy to sell at $25 netting almost 10% profit.
Selling Covered Calls
Because I am happy to sell at $25, I am willing to sell a covered call with a strike price of $25 per share. Since each contract covers 100 shares, I could sell 10 contracts expiring in January 2012 for 67 cents per share. So what have I done?
First, I have collected $670 premium for selling the call options. I get to keep that money no matter what happens to the stock between now and January. If it remains below $25, then I keep the premium and the stock.
In January when the contract expires my obligation ends, and I can sell another call against my Intel stock. I still get the dividends which would be 36 cents per share plus an additional 67 cents per share making my yield $1.03 on a $22.60 investment or 4.5% for 6 months or 9% annualized. That is nearly triple the dividend yield.
Should INTC trade above $25, I could have my stock called away from me. Then I would have the 67 cents premium, the capital gains of $2.40, plus whatever quarterly dividends got paid out before the increase in stock price. That’s a minimum of $3.07 profit on the $22.60 investment for a six month (or less) return of 13.5%. I’m not going to complain about that.
Afraid Stock Might Rally
If you are afraid the stock might rally, then only sell calls on half the position or 500 shares. The others can freely participate. I do this frequently in my retirement account with some of the more volatile stocks. You can even get somewhat creative and sell some calls that expire in October and some in January. The are many possibilities.
So what do you think? I would love to hear your comments below. Don’t know enough about options? I am working on a site that will be a complete tutorial at Options Dude A to Z. I would love to share what I have learned over the years and my own personal experiences.
I ran across this post on “Catching Falling Knives” at The Market Capitalist and felt that it was a great topic for my first post on options here at Cash Flow Mantra. Most people would be scared to catch a real falling knife, but if you do so with a little bit of practice and training, it can be done relatively safely. It can even be entertaining as seen here:
Now if I were to catch a falling knife, I might do so with a block of wood or a chain mail glove to keep from getting hurt. But if I want to catch a stock in free fall, I would do so with put options. Allow me to explain how to catch a falling stock by looking at a real life example.
Recently, Linked In (LNKD) issued stock in a much hyped IPO. The stock opened at over twice the offering price and shot past $120 per share, but then immediately began falling. There have been questions about valuation and earnings, but I am not interested in debating that. Rather, I am interested in how could you get involved in the stock not knowing where the bottom might be and still not get hurt!
It didn’t take long for options to start trading on the stock so here is what I would have done had I been interested. You could consider this type of strategy for Facebook when it comes out since it is likely to be a stock that will have some hype involved.
Let’s say that you would have wanted to get 500 shares of Linked In. That first day of trading it would have cost $50,000. But the stock started declining right away. Within a few weeks, the stock is at $70 per share. Is this a bottom? How low will it go? I have no idea, but I do have a plan.
When the stock is at $70, I could purchase 5 contracts of the $60 put that expires in November for about 25% of the value of the stock or about $17.50 per share. Each put contract covers 100 shares. The puts are very expensive for this stock since volatility is still high with real potential downside risk. Then I purchase 500 shares. So, what have I done?
I own LNKD and can brag to everyone at work. But my cost for the stock and the put options is $87.50. If LNKD is trading at $30 in November, then I can sell it for $60 but I will still lose $27.50 per share which is better than $40.
Alternatively should LNKD increase to $100 again like it did today on July 11, I will make a profit of $13.50 per share on the stock plus whatever value the puts may hold. Could LNKD go to $150? Sure. That would be great if I owned the stock. Could it go to 30? Sure. That would be terrible if I owned the stock.
The point is that puts can be used to limit the downside and allow you to pull the trigger on a falling knife. Puts are that chain mail glove protecting you while you practice juggling those knives. No sense losing a finger or a lot of trading capital.
There are even techniques that can be used that might even allow you to profit from a falling knife, like buying 8 or 10 put contracts on those 500 shares and selling off the puts one at a time as they increase in value and you wait for a bottom.
I use puts in my retirement accounts to double down and buy into a declining stock. I sold EMC from my account last November after holding for 3 years. My original purchase price was $25.37 in October of 2007. I watched it drop into the low teens but because I made money on the puts and was able to purchase additional shares with confidence knowing that it would eventually recover somewhat. I sold at $21.82 but made 8.7% annualized return over those 3 years because I averaged down. My basis ended up being $15.78.
I was able to invest without fear knowing that I couldn’t lose all of my capital. Plus, I made a better return than buying and holding in which case I would have lost money.
So reader, have you traded options? Do you think options are risky? Have you any idea what I was saying? Please offer your comments below. I will be working on another site that will start at the beginning and explain options in a simple manner so that anyone could understand and appreciate them.
Most blogs offer up some favorite links for weekend reading so I figured that I might do something similar although I don’t know that I will do this on a weekly basis. I am thinking that once I run across about 5-10 articles that really strike my fancy, I can post the links and make some comments about them as well.
These articles are probably going to have to be pretty unique and newsworthy for me to include them since many of the articles will rehash other material found on the net. Not that there is anything wrong with that, but I would prefer not to include links just to include links. I want to offer up some value and stimulate thought and discussion. I also would like the post to be somewhat practical with helpful tips or strategies that might improve your financial situation.
With these criteria in mind, I would like to offer up my first set of links to articles that I found incredibly helpful and produced an “Aha!” moment when reading them:
Simple “Hedge Fund” Investment Techniques for the Average Person at Trees Full of Money. This post discusses how the average person can “hedge” against the volatile price of gasoline. For me, whose family members (4 drivers) drive close to 60-70,000 miles per year, this information is huge. I hadn’t thought of using the ETF for unleaded gasoline to hedge my fuel costs. The correlation of UGA is over 95% as well so it does a good job of tracking and could smooth out my cash flow immensely.
How to Invest in a Bubble at Investorzblog. This is good practical advice although I don’t think the author carries it far enough. But it did give me a great idea for a post that I will write when I get back from vacation in Dallas.
Finally, I really enjoyed this post at 101Centavos who asks, “Are the United States Going All Greek?” It is filled with some interesting data and good thoughts. The discussion is pretty good as well. I have no idea what the future will hold, but I do want to start preparing for many different possibilities and financial freedom will help toward that goal.
So, there you have it. I only have 3 with this post. I want to get it scheduled before I go on vacation. I have no idea what I will be able to do next week. Enjoy.