In my last post, I updated many of the changes that had occurred in my positions due to options expiration last Friday. Well because of those changes, it has been a busy week and I have had a lot of additional adjustments happening so I thought I would make a few comments.
As you know, my position in Silver Wheaton (SLW) was sold due to the exercise of the April $30 put options. I bought back one-third of that position at $28.50 plus a few more shares at $28 snagging a significant discount. Now I went ahead and sold some May $29 calls for $1.25 per share meaning that I will have made the $1.50 discount on the repurchase, $1.25 on the premium, but lost $1 for selling at a lower strike. However, the net will be $1.75 per share profit provided that the stock gets called away.
Yesterday, I was able to buy back the next third for $29.90. I still have the stock uncommitted so I could sell some additional calls. Gold and silver are up a little this morning. I suspect the weak GDP number means that traders are thinking the Fed might have to get more active in trying to stimulate the economy and inflation expectations down the road have been heightened. Who really knows? I will keep trading my system month to month. Right now, I am working on decreasing the basis in SLW so any shares that I add will do just that.
Do to the discount that I got in the repurchase and cash from selling calls, I think I might be able to add some shares to be ready for the next upswing. As I work out my position in AKS over the next few months, I want to use those funds as well to add additional shares of SDRL and SLW.
This has been a big week in Onyx Pharmaceuticals (ONXX). Buyout rumors caused the stock to pop over 8% on Wednesday. I ended up buying back some May $40 calls that I had sold as well as some May $42 calls. I then sold some May $45 calls and plan on selling some $47 calls when I can. Unfortunately, yesterday was sideways and today is looking somewhat weak to start out. I may just buy some put options to protect some of the gains and see what happens. I would hate to not be able to take advantage of a nice little spike, but if the rumors dissipate then the stock will languish for sure.
Other Calls That Were Sold on Strength
I also managed to sell some SDRL May $38 calls, STX May $30 calls, and INTC May $28 calls on strength yesterday. I had simply placed some good-til-cancelled (GTC) limit orders earlier in the week and they happened to all hit yesterday. It was definitely a good thing with STX since it looks to drop about 8% today. Let me tell you, volatility can be crazy sometimes which is why I have many protective puts since it is impossible to know how the market will react.
Recently, Joe over at Retireby40.org discussed his options for a $50,000 emergency fund, and I must confess that I thought they were rather poor. Not that Joe is making poor decisions, but his options for investing this money are pathetic. A 5 year CD paying 2.25%? That is a guaranteed loss of purchasing power because you know that after taxes and inflation are taken into consideration, the value will be down!
Now Joe has certain requirements, and I am not trying to change his mind regarding them. But he did ask the question posed in the title and since my answer was going to be longer than could be held in a comment, I thought I would write a post about it.
How I Would Manage $50,000
I have to assume that Joe is debt free (with the possible exception of a mortgage) so I would make sure that I am debt free as well. I also have to assume that there is some savings in Joe’s budget so that he might be adding to this fund at a rate of $500-$1000 per month. You don’t want to be quitting a job with a budget that is tight.
I also have to assume that the likelihood of needing all $50,000 within one month is incredibly slim. What emergency costs that much? You should have other insurance to cover major medical or disabilities or liabilities so needing the whole sum at one time would be unexpected. So having access to half the money rather quickly seems reasonable to me.
Invest in Stocks
So, I would invest in stocks. Now I know it doesn’t meet Joe’s requirements but hear me out. Investing in a margin account would allow you to access half of the equity rather quickly (within one week). The interest rate on that at ETrade is 8.44% which is likely better than a credit card. Again, how much will be needed at one time?
But there is the concern about loss of principal. Now I am just as concerned about loss of money as much as the next guy and possibly even more so as I get older. This is why I use protective puts. I would look for large company stocks that pay dividends but might be slightly volatile so that they pay a good premium on covered calls. Then I would buy some puts, sell some calls, and collect the dividend. I would probably split the money in two portions and invest in one energy and one tech stock.
For example, I might choose to purchase 1000 shares Intel stock (INTC) at $26.38 and purchase the January 2013 $22.50 strike put option at $1.47 per share. I am choosing the longer term put because the cost per month of protection is relatively low. Thus my total cost is $27.85 plus commissions or $27,850.
I would then sell the April 2012 $28 strike calls for 42 cents per share lowering my basis to $27.43. Now if the stock heads above that price by April and stays there so it gets called out, then I have made 57 cents in profit plus the 21 cents quarterly dividend or $0.78 on my $27.43 investment. The yield is 2.8% over 3 months which is much better than a five year CD. But let’s not forget that the put option has an additional 9 months of time value left which can be sold for additional profit.
Rising Tides Are Easy
So it is easy to make money when your stock increases in price, but the real problem is the risk involved. What if the stock drops like a rock? The most money that is at risk is the difference between the basis of $27.43 and the put strike price of $22.50. That is $4.93 which represents an almost 18% loss of capital! That sounds too risky. But we will collect 84 cents in dividends over the next year so we would only lose 15% instead. But still losing 15% of an emergency fund is not fun.
However, this is where it is important to be able to add to the fund. If you are adding $1000 to the fund each month, then an additional 100 shares could be purchased in 2.5 months. If purchased at a lower price, then the basis will decline and additional calls could be sold after April. Eleven contracts could be sold at that point. The strike may end up being the $27 strike so this may help cushion the loss. Additional shares also means additional dividends which can be reinvested.
Now if the stock ends up $15 in January 2013, that is OK. The puts will be exercised at $22.50 giving the investor $22,500 which can then be used to purchase 1500 shares. If this is all that happened between now and then our original basis in the stock is $27.43 minus the 84 cents in dividends. The new purchase drops the basis even farther to $17.73 which would make selling a $17.50 call option a possibility.
The bigger risk is a slow grind down to $22.51 where the investor has difficulty managing the covered calls from April to the following January. That is where some experience helps as well as being able to purchase additional shares during the year to bring the overall cost of the position downward as the stock declines.
The bottom line is that I would be putting 15% of my capital at risk in order to earn about 5% over 3 months. To me, that is reasonable which is why personal finance is personal. You would never catch me investing in a CD in a negative real interest rate environmental. Again, a personal decision. But, since the question was asked, I answered it.
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With having been in South Carolina on a golf trip over the past week, I hadn’t really done any round up or link posts, but I do want to highlight those carnivals CFM has been in these past two weeks. Be sure to check them out. A big thank you to all the sponsors.
How appropriate is it that we should wrap up our discussion of covered call time premium for the week on the day before option expiration? Even though options expire tomorrow on Saturday, today is the last day that they could trade. So for all practical purposes, I consider the third Friday of the month as the more important day when it comes to trading options.
Additional Factors Affecting Options Prices
We have already discussed a couple of the factors that influence the premium that one might receive for selling a covered call and will summarize those at the end, but another important factor that can influence the price of an option contract is the volatility of the underlying stock.
This should make sense since the way to profit with an option is by having a significant change in the price of the underlying stock. If a stock only typically moves $5 in a month, you can bet that options priced $10 away from the market price have very little value. However, if the stock is highly volatile and will move $20 up or down in a month’s time, then that same contract would be worth a lot more.
Finally, one needs to consider the impact of interest rates and dividends on the premium of a call option. In a higher interest rate environment, the call premiums tend to be higher since the cost to purchase shares of stock outright with borrowed money is more. This makes a call option a viable alternative as a form of leverage and so the price increases somewhat. Of course, this will benefit those selling covered calls.
On the other hand, a stock that pays a dividend will tend to have a lower premium since the stock should be losing value when it goes ex-dividend. On a side note, dividend paying companies tend to be less volatile.
Five Factors that Influence Call Option Premiums
To summarize, there are five main factors that work together to determine the ultimate price of a covered call:
- Relationship between the stock price and the strike price
- Time until expiration
- Volatility of the underlying stock
- Prevailing interest rates
- Dividends paid by the underlying stock
That concludes this week discussing covered calls and premiums. Feel free to ask any questions or suggest topics for the future.
Don’t Forget the Cash Giveaway
There are only 5 days left (ends January 25th) in the cash giveaway celebrating my 100th post here on CFM! Be sure to enter!