rolling out

May 30th, 2011

TEVA, an Israeli pharmaceutical company, seems like a very well run company. Because of the industry, the stock fluctuates quite a bit, which creates large option premiums. Last November, when the stock was around $50 or so, I bought 100 shares at $50.50 and sold 10 of the 55 June calls (7 months out—longer than usual) calls and took in $1,300. By May of 2011, with the stock moving between 45 and 55, I bought back these calls for only $65, and resold the December 55 calls and took in $2,800. The stock is still around $50 this week, about what I originally paid for it. If the stock goes over $55 and is called away, I will let it go and take the $5,000 profit on the stock price, along with the option premiums collected. If the price stays the same or declines, I will just keep writing options against it, and expect to make 8-10% on my money.

This is called “rolling out,” which means that you buy back calls which, because of time, have become less expensive than when you sold them (SELL HIGH, BUY LOW), and sell new calls at the same strike price but with a later call date.

HERE IS WHAT ONE HOPES WILL HAPPEN–AND IT DID

May 24th, 2011

Today let’s talk about how options SHOULD work when everything goes right.

When the big oil spill happened Transocean (RIG) and British Petroleum (BP) stocks plummeted. So I bought them. Let’s look at what has happened with RIG:

I bought 1000 shares at $60 (which was not the low). I sold 10 calls at a strike price of $75 against the stock at the end of November and took in $4,420. The stock might have gone over $75 for a short time, but by and large it has languished below that, and I kept the premium. This week when the stock was at $69 I decided it had had most of it’s run up for now (although it’s still a really good company) and I’m ready to get out. So I sold 10 August calls with a $70 strike price and took in another $4,000. With the stock at $69 I’m ahead almost $9,000 on the stock.

So I’m $8,400 in hand from call premiums, and so far $9,000 ahead on the stock. Of course it’s not over until it’s over, and the stock might drop (with the rest of the market).

If the stock goes back up over $70 I will make a profit of $18,400 on my $60,000 investment. That’s $10,000 on the stock ($60-$70) and $8,400 from option premiums. Even if the stock were to drop back to $60 the option premiums would still be in my pocket. Only if the stock were to go to about $50 would I lose money. I don’t think that will happen this year.

Long term investing

May 18th, 2011

My dad used to say that the only way to make money in the stock market was to buy and hold. So this month I Checked the Fidelity Fund tech funds to check out dad’s advice.

If you held the Fidelity electronics portfolio for 10 years your average annual return was 1.51%. Yes, last year you made 18.31%, but that off a very low base. Not a good long term holding.

The best you could have done was the software fund, which averaged 9.93% over 10 years. But again, most of that was the 24.34% from last year. So during most of the ten years you didn’t do so well,

That’s one of the reasons I like option writing. The market moves fast. Companies change quickly. It seems better to me to buy what looks good now, with some dividend, and enhance the return with options on a 3-6 month basis. The return seems much more likely to be greater than buying stock and holding long term. And, if doubts creep in you can always hedge.

I still think REMX is a good candidate for covered call writing, as well as VXX. Please review my earlier blogs on these positions.

Merv

I’ve been a busy boy in the market.

May 9th, 2011

I’ve been a busy boy in the market.

As I threatened to do in a prior alert, I bought 100 shares of VXX as a hedge against a decline in the market, and paid $28,000 for the position. It’s been down ever since, but seems to be coming back.

At the same time I sold 10 calls of the VXX September 29 calls and took in just over $3,100. So my net cost for the two positions is about $25,000. The VXX is over $25 at the moment, so I’m still ahead, and I’m nicely hedged against a decline in the market (although the VXX is activated primarily by volatility, it does seem to go up when the market declines).

This should be fun to watch.

I still hold the BP stock I bought during the big oil spill. I paid $48 and it’s still down at $46, but I’ve sold calls against it twice. I’m currently short the Sept 47.50’s for which I received almost $2,000, so I’m ahead in cash and cannot lose on the position unless the stock goes down again. There is no reason to think that an oil company stock is likely to go down in the current economy.

I did well with the REMX rare earth position, and I still recommend it. I sold a put to pay for a call, and when both were profitable I sold the put, taking the profit on that one, and hold the call now at no cost. I’m sitting with an $800 profit on that position in the call.

I closed out the Cisco put at a small profit as mentioned in my last note.

Finally, I’m still sitting on 1000 shares of RIG at a handsome profit, and not taking the profit quite yet as I’m short the May 75 calls. Those too are profitable so I’m coming out ahead both on the stock and on the calls. I’ll give you the final results after the expiration date this month.

As you can see, options are a great way to protect profits.

mlh

May 6th, 2011

A valued reader asks:

” So what’s your philosophy on covered calls where the stock price has dropped below what you paid for it?

Will you write calls that will give you a loss on the stock if executed? Calls above your buy-in price may have premiums too low to be worth selling.

Will you follow it all the way down?”

My answer is that “it depends on my evaluation of the stock.” Sometimes I realize that I’ve misread a company, and I lose confidence in it. When that happens I get out, and put the money somewhere else. That happened to me this week. As you recall, when Cisco was about $19 I sold the $20 puts, thinking that it would go up above $20 within the next quarter. But the news from Cisco has demonstrated a poorly run company, and the stock has declined to about $17. Fortunately, and this is one of the wonderful things about option writing, I got enough premium on the sale so that even though the stock declined more than 2 points, in closing out the stock and the put I still made a small profit of a few hundred dollars. Some say that Cisco is now poised to jump. I don’t care. It doesn’t look like a good company to me right now.

BUT, most of the time I stay the course. I’ve held MDT for years at below my cost, writing call after call, and taking in a nice return on my investment. The same is true of WAG. Those are still good companies, in my opinion, and I’m holding on to the stock, collecting the dividends, and writing calls sometimes below my cost. If the stock moves up to the strike price of the calls I buy them back, typically at about what I paid for them, and write a new call at a higher strike. Even if I occasionally lose a small amount in rolling up, in the long run I’m way ahead.

merv

Reply to Harvey regarding– why ever own stock?

May 2nd, 2011

Merv:

In looking at the structure of time premiums, it seems to me that the best way to milk profits from a non-volatile stock, is to sell on, a monthly schedule, the option in the nearest month with the nearest strike price.

This works because the time premium per month falls off faster than linearly, so e.g. you make more by selling a 1-month option every month than by selling a 3-month option every 3 months, all else being equal. (My commissions are low enough that this applies even considering the 3x greater commission costs.)

OTOH, if a stock is so volatile that you’re pretty sure the nearest strike price option will be executed soon, you’re better off selling the furthest month option available, because of the big premium and because you’re likely to be executed upon soon anyway, so you can sell another one sooner. Obviously I’m assuming in all this that you have a fixed fund that you’re turning over, so you don’t take a new position till an old one expires.

How likely is such a long-term option to be executed when it hits the strike price early? Is it reasonable to assume that it will be immediate?

Have you looked into using published beta values to figure the probability of a particular point move in a month? That would help determine how far out to sell options to maximize monthly yield.

These strategies should apply both to selling puts to get the stock and to selling covered calls once you’ve got it.

Harvey
REPLY:

Yes, technically there is more decay within the last 45 days of an option’s life. But the premiums are not very great, so you have to write a lot more options, and it’s a big time commitment with a lot of transaction costs. That’s a better strategy writing naked puts.

In terms of hour question about why own the stock at all, why not just write naked puts, in fact, put premiums tend to be higher than call premiums for the same risk levels. The only reasons to own the stock is, as you say, for the dividend, and secondly for margin purposes, including account rules. In many accounts, such as retirement accounts, naked puts are not allowed. When they are allowed there are high margin requirements, so in effect you have to put up as much money as it cost to buy the stock.

I get around that by buying bonds and using them as security, but technically cannot prove that is a good idea historically. I really like selling calls against high dividend stocks.

Merv