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BASICS FUNDAMENTALS TECHNICALS ROLLING TC-2000 OPTIONS |
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In this section we will continue the options tutorial, moving through a
review with some added detail on options pricing, including one way to find candidates for this strategy. Some brief comments on when to write covered cals, then an actual transaction.
Options in general increase the inherent risk in investing because they are fixed-time investments. An option does expire! With a stock, if the price goes down we can just wait it out. We don't lose money until we sell. Such is not the case with an option.
That said, why are we spending time delving into the world of speculation when our objective has been to reduce risk, to seek ways to improve returns without biting our nails to the bone? Simply, by selling call options on stocks we own, that is, "Writing covered calls." Let's try to understand with a brief review of some option definitions.
Covered option writing is a misunderstood strategy. Unfortunately, it has been confused with speculative option buying, where the losses can indeed be significant. On the other hand, writing covered options (calls) may be as conservative as buy & hold investing.
Options: "We can buy or sell the right to buy or sell a stock at a predetermined price within a specified time frame."
How's that for double-talk. Actually it is more than double, since it includes six different conditions. Let's make it easier:
1. We can buy (pay for) the right (but not be obligated) to buy a stock at some specified price in the future. We are not obligated because we have paid the money. We are in control and can choose to buy the stock or not. We do this hoping the stock price moves higher than the specified (strike) price. We can then pay for it at the lower strike price then sell it immediately at the new (higher) market price for a profit. This right for which we have paid is termed the "Call."
2. We can sell a call for some specified price at a future date. We obligate ourselves by accepting someone's money and must comply if the buyer exercises the option. We do this to generate immediate income, setting the strike price where we are willing to sell the stock. We accept the loss of control over the stock until the option expires, when we are either "called out," that is forced to sell the stock at the strike price, or when the option expires worthless.
Conditions 4-6 designated above deal with Puts, which are the right to sell a stock, to "put" it to someone, at some strike price before expiration. We will cover Puts in later editorials when we look for greater rewards accepting more risk.
1. Writing covered calls
Now to deal with writing covered calls. When we sell a call on a stock we own, the only thing that can go wrong is with the stock itself. The stock can go down. But we already have that risk. Selling a call does not increase the risk on the stock. It does tie up the stock however, for the duration of the call. There is NO risk on the call itself. We receive the premium into our account the next day when the call is sold. That cannot be taken from us.
- A covered call can be written three ways:
- Buy the stock and sell the call at the same time.
- Buy the stock and sell the call at a later time.
- Sell the call on stock we already own.
2. Option Premiums
Last section we considered the important factors that help determine options premiums, or what they cost. If an option is a promise to act in a certain way, given a specified set of circumstances, what is that promise worth?
We found the following:
- The price of an option has two basic parts:
- Time
- Value
- Time relates to hope and/or expectation. This portion of the price is set by market
makers based on several factors, including:
- The amount of time left before the option expires
- The price of the stock
- The volatility, the expected movement or fluctuation of the stock price. (The greater the volatility, the higher the time-premium).
- The interest in the option (the more investors trying to buy, the higher the time value, supply/demand).
- Value depends on where the stock price is relative to the strike price. It the stock price is above the strike, the option has intrinsic value. When the price of the stock is below the strike price, the premium has only time value. Three conditions are so named:
- In the money - the stock price is above the strike price
- At the money - stock price equals strike price
- Out of the money - stock price is below the strike price
[A $10 call on ABTX, currently priced at $8.13, is $1.87 out-of-the-money. The same stock is $0.63 in-the-money on a $7.5 call.]
Option premiums are proportional to the relationship between the stock price and the strike price. We will pay more for an in-the-money call than for one out-of-the-money. However, when we "write" a covered call, on a stock we own, we are selling the call. The buyer is paying us and will therefore pay a higher premium if it is in-the-money.
The further the stock is in-the-money, the less its time value. The greatest time value occurs at-the-money because the stock price is the same as the strike price. As a seller we want the most time value, therefore we should sell at or near the money.
As an option buyer, the conservative play is to always buy in-the-money, paying less for smoke & mirrors (time value is fleeting, it decays to zero).
3. When should we write a covered call?
Covered calls make sense when:
- We have a stock in our portfolio that we are neutral or mildly bullish about and would be happy to sell it at a near-market price. In such a case we pick a strike price that we are comfortable with and pick up immediate cash as we wait for the expiration date. If we are called out, we keep the option premium and pick up some capital gain on the sale of the stock.
- When we are willing to forego possible gains on the up-side to put some cash into our account now.
- When we want to be paid for accepting the obligation to sell a particular stock at some specified price on or before some date in the future.
When covered calls don't make sense:
- When we expect a stock to strongly move higher. We do not want to limit our potential return by tying up a stock.
- When we do not want to tie up the stock, that is, when we write the call we can only wait for expiration. That may be a "nail-biter" for some. There is the possibility of "buying back" the call to wipe the slate clean and then deal with the stock as we choose. There is a cash penalty for that action, however.
We need to get into a "selling" frame of mind as we start dealing with covered calls. That is, we are looking to get out of the position in a relatively short time, rather than the "buy & hold" tradition.
To do this, we need to set some ground rules:
- Find optionable stocks in the $5 to $20 range. This is to limit the outlay in cash necessary to get started. If we have big bucks we can find great plays in the more expensive stocks.
- When possible, select stocks we expect to move higher or sideways in the short term (3 to 8 weeks).
- Select stocks from this data-base that have option premiums that are at least 10% of the stock price. That means if we buy the stock for $16 and turn around and sell the call for $1.60 or more, we have a 10% return in the time to expiration. On a margin play that could be doubled. This return is whether or not we get called out with the attendant capital gain.
- If the stock is in a positive trend upward, we may wait before selling the call to gain a higher premium on the call. They don't have to occur simultaneously.
- Sell the call near the money to garner the best premium.
- Choose an expiration date that is relatively close, usually the next month out. We need to give ourselves at least 3 weeks but not longer than about 8.
An excellent exercise to locate candidates for writing call is to go to either the Wall Street Journal or the Investors Business Daily and scan the most active options listed. This week's scan in both papers found 302 listed options in WSJ and 794 in the IDB. These are not necessarily the same options nor all of them. Checking into the Investors Tools in the www.cboe.com which is where it all started, there are 2759 listed options.
The scan proceeds in this way:
- Find the page in the paper with listed options quotations (page C14 in today's WSJ, page A26 in IDB).
- Note with a pen or highlighter those that meet the price criteria (I scanned only five columns on the top left side of the page in IDB for this example, covering 122 stocks, finding 24 in the $5 to $20 range)
- Now look in those you have marked for an option premium to stock price ratio above 10%.
I found eight candidates (looking at only 15% of the listed options in this paper):
Name Price Option Ratio (%) Strike Able Telcom $10.50 $5.50 52 $5 Acclaim Ent $9.25 $1.63> 18 $7.5 Agribiotech $8.13 $1.06 13 &7.5 Andrea Elec. $8.88 $1.38 16 $7.5 Applied Magn $5.00 $0.56 11 $5 Collagn Asth $13.00 $4.63 20 $15 Columb Labs $5.00 $0.50 10 $5 ComptrLrnCt $5.13 $0.63 12 $5
- Are any of these good candidates? I don't know. This is where we begin our study of fundamentals, technicals, and a search of the news. But we have a good place to start.
5. An example
The following example is a $15 covered call written on 10/16/98 on FORE, called out 40 days later on 11/20/98. I put up $2000, buying 300 shares on margin, obtaining 300 shares at 12 11/16. The net return as shown was 36.9% in 40 days after all commissions and expenses.
The stock price did rise above the strike and I was called out. That provided a nice capital gain as shown. Had I not been called out, I would have been free to sell a call for another month. In either case I was able to keep the option premium which netted 8.8% of the return.
As you get into this you will find that most option are never exercised. That is, they expire worthless. When exercised, they are usually called just before the expiration date.
This example concludes our tutorial-set on using options as an "income" factor in our trading strategies. This can be an asset with rolling stocks because the research and home-work we do on one can be used on the other. Additionally, many covered-call candidates will turn out to be solid rolling stock candidates, and vice versa. May this combination work to all your advantages in building a sound financial base.
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