I have lost plenty of money in the stock market over the years and have discovered that I really don’t care for it. I have also discovered that I am not a good stock picker. Therefore, I have been using stock collars to hedge my selections since 2007. This turned out to be a good thing in 2008. As others were watching portfolios fall 50%, I only lost 18%. I could have done even better, but I did make a few mistakes as I was still in the process of ironing out my system.
Now I spend about 5 minutes researching a stock before I buy it. I don’t look at a balance sheet or statement of cash flows. I simply look at the option chain. So when I read an article about Seadrill last year, I took a glance at the options and figured that I could make money on this stock with the dividend. It is a little more difficult using collars when trading a stock with a dividend since the call premiums are reduced. You might want to check out my articles on options pricing:
- Selling Covered Calls and Time Value
- More on Covered Calls and Time Value
- More Factors Affecting Covered Call Premiums
But before we get too far, let’s explain what a collar is. A collar involves owning a stock, owning a protective put on the stock, and then selling a covered call against the stock to help offset the cost of the put option.
Example Using Seadrill
So when I look at the current option chain for Seadrill (SDRL) and want to set up my initial purchase, I find that with SDRL trading at $38.37, it is near the top of its 52-week range which it hit on March 1st of 2011. This makes me a little nervous knowing that this will serve as a point of resistance. I may end up being a little cautious as a result.
Lets say that I want to buy 100 shares of SDRL because I like the dividend yield of over 7% and think that oil prices will stay high. What I would be doing is purchasing a put option with a March expiration and a strike price of $35 per share for 45 cents per share. Then I would purchase the stock at $38.37 and sell a covered call with March expiration and a strike price of $39 at 55 cents per share. So what have I done.
First, I have gotten a slight discount in the price of the stock since I made more money (10 cents) on the sale of the call than it cost me to buy the put. Now commissions would probably wipe that out, but trading for free is not bad either. If SDRL continues to increase in price and is above $39 on the third Saturday in March when options expire, then my stock would be sold at $39. I would essentially make about 63 cents per share on a $38.37 investment in 6 weeks. That is a 1.64% return which works out to just over 14% annually. Not bad for a few minutes of work.
But the problem is what happens if SDRL doesn’t increase in price. It is easy to make money in a bull market. The trick is not to lose your shirt when everyone else is so that you can live to trade another day. Well, if SDRL drops in price to $30 per share by March expiration, I am not worried. I sleep just fine thank you very much. Why? The protective put will be exercised and the stock would be sold at $35.
But you lost money, I can hear you cry! Over 8%! So what?! The stock lost 21%. My loss is less than a third what the market lost. And guess what I do. On Monday right after SDRL sold for $35 and I have $3500 in my account, I purchase back the stock to average down my cost. And better yet, I can buy 116 shares instead of 100 for the same cost.
The Biggest Problem
The most difficult situation comes when SDRL commences a slow slide to $36 per share by expiration day. Both options expire, and I am looking at a $2.37 per share loss. The$35 strike April put is more expensive than the premium I can get for the $39 strike call option. To stay in the trade, it will either cost me money or I have to roll downward to a $33 strike put and a $37 strike call. This will lower my basis in the stock a little, but would result in a loss if called out at $37.
With this situation, I will end up adding to my position slowly over time to decrease the overall cost of the stock. It takes patience, sometimes up to 2 years. But it is possible to turn a loss into a gain using stock collars.
For example, I recently closed a position in AKAM. I purchased the stock at $40.26 on February 22, 2011 and sold when it was $32.04 on January 20, 2012 which normally would mean a loss of just over 20% in eleven months. By using collars and averaging down, I ended up making 13.36% on the trade over those 11 months which is not a bad return
For the 27 trades that I have closed since 2007, I have made money on 26. The losing trade was simply because I wanted out of the stock to try something a slight adjustment I was making to the system back in 2008. I am still holding on to my big loser just to see if it is possible to turn a profit on a near-death experience. I purchased in 2007 when I was still figuring this all out.
The trick comes from knowing what adjustments to make once the downward movement occurs and having the patience to massage the trading and put yourself in a position to profit from a rebound while waiting for it to occur. But as illustrated with AKAM, the rebound can even be a partial one.
Ultimately, I think that it would be fun to manage money using a system such as the one I describe. It isn’t hard but little errors here and there can trip you up. I feel that I have ironed those out in my own system but need to deal with a few other priorities first. Feeding the family is priority number one. In the meantime, I will continue to work with my retirement accounts and see what results I can achieve using dividend paying stocks. I am thankful for the experience that I have gained since 2007 especially with the difficult market conditions.
Feel free to ask some questions.
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!
In the last post, we learned that the greatest time premium for a given expiration date occurs when the strike price is close to the market price. So the relationship between these two prices ends up looking like a bell-shaped curve. Now let’s look at another factor which influences the amount of time premium.
Time Until Expiration
It should only make sense that the amount of time premium should be greater if the amount of time is longer. An option contract that expires in one month will cost less (or sell for less) than one that expires in one year. Again using actual data at the time of this writing for Silver Wheaton stock (SLW), I have created the following chart of premium versus time for the call option with a strike price of 30.
Now at first glance it would seem that selling calls that expire in two years would be smarter than selling calls that expire in one month. However, you have to remember that the graph is not to scale and to make a more fully informed decision, we should divide the amount of premium by the number of months until expiration. When we do this, we find that the shape of the graph changes dramatically as you can see below.
So we could sell the call option expiring in 2 years for $8.65 per share, or the one that expires in a month for $2.02 per share. When it expires, then sell the next one for $1-2 per share and repeat the process month after month making $30 or more in covered calls premiums over the course of two years.
For me, I am interested in making money from selling call options in my retirement account so I will sell them about one month out on average. Sometimes I may wait to see if the market will have a good day and end up selling them 2 weeks away. If I miss that window, I may end up selling covered calls that expire in 6 weeks.
Now if you want to purchase calls, then it is wise to purchase them to expire later so that you get more for your money, and the stock has more time to move in the direction that you would anticipate which would be higher. After all, the way to profit from purchasing a call is to sell it at a higher price which can only occur when the stock increases in price.
Again, I think that this is a very important concept to grasp and understand, namely, the time value per unit of time is greatest with the options that expire sooner. Feel free to ask any questions.