Covered Call Strategy with American Oriental BioEngineering

Over the weekend, I went to a 19th Century Village Restoration on Long Island showcasing homes and businesses from Long Island during 19th Century. The Village had all the characters in uniform acting as the very people who lived or worked in the homes or businesses back then. The hat maker, working in his little shop with his wood burning stove actually made a good living. He made his hats and would sell them in Manhattan for cash to a wholesaler. He saved his money and bought a 600 acre farm according to the bearded man playing the role of the hat maker. His 600 acre farm was his retirement fund. He could rent it out, mortgage it off for monthly income or hire labor and farm the land for profit. It was good old 19th Century financial planning.

What about today? What are some ideas for passive income to retire on or simply earn an income from? Lets assume you have $250,000 to invest. What can you get from $250,00 today for monthly income?

Yields today are rather paltry and I don't know about where you live, but where I live, the cost of most things I buy are going up: Sugar, Gas, Tolls, Stamps, Eggs all up. Inflation in stuff I buy is going up more than the rates above. I need to do better!

Management of my risk is very important. If I want to speculate, I'll go to the Belmont Stakes on June 6th with the $250,000 and let it ride on the favorite to Show. But of course, I won't.

I have an idea that I think warrants some of my investment funds that I believe provides a good risk reward.

It begins with shares of a stock I wrote about in March, American Oriental Bioengineering (AOB). I recommended it at 3.98 a share suggesting it was in the bargain bin based on valuation.

Shares of AOB are currently 4.56 per share. With the whole $250,000, I could buy about 55,000 shares today.

The January 2010 5.00 call is being bid for 1.00. I could sell 550 of the January 2010 5.00 call for $55,000 in premium. That would reduce my cost basis by 1.00 to 3.56 not including any transaction costs. The option expires in less than 8 months and the yield of the premium based on the cost of the investment is 22% ($55,000/$250,000). This substantial yield over the less risky investment offers the reward that I believe compensates the risk.

I tell myself, if I can make 10% a year, I'm doing terrific. For me to make 10% per year on my $250,000, I need $25,000 in income or $2,083 per month. Because the premium received is $55,000 over 8 months, taking $25,000 over 12 months provides a considerable cushion as I'm provided with more than enough premium. If AOB is below 5.00 per share come the 3rd Friday of January 2010, I could sell the June 2010 5.00 calls again for more option premium. If AOB goes above 5.00, I would lose my shares at 5.00 making an additional 44 cents per share or $24,200 in capital gain. My total maximum profit would be $79,200 ($55,000 in option premium + $24,200 capital gain = $79,200). That would be a gross return of almost 32% in 8 months.

From the chart above, I'm not going to get $25,000 per year on any of the choices I have. The most I will earn from passive income would be $11,500 from a dividend on a stock such as Kraft Foods (KFT) which is yielding 4.6% currently. Kraft has a lot of debt and given the recent rise in the 10 year treasury yield, if the cost of that debt becomes too high to service, Kraft may have some significant problems down the road.

AOB I believe offers a decent risk reward for a long term investment and also offers considerable income for utilizing the strategy of buying shares and selling longer term out of the money covered calls.

Disclosure: Long AOB for myself and my clients

Comments

[Graham Jervis:]

i went a bit further with AOB, what i have is a covered call and also short the put option. So i reduced my initial capital outlay a bit more. I learnt this from Paul Price who also writes on Seeking Alpha. Obviosuly the risk to my trade is i might be put the stock should it be below 7.50 by 2011, thats a risk i can live with. What i did back in February 09 was to buy 100 shares of AOB at 4.83 for 492.00, then i shorted 1 Jan 2011 7.5 call for 1.40 and got back 128.50, then i shorted the Jan 2011 7.5 put for 4.00 for 388.50, so my initial cash outlay is 492-128.50-388.50 = -$25.00 or a gain of $25.00 immediately. Here is how it will play out for me.

Come Jan 2011, if AOB>7.50, then my put option expires worthless and i have to sell 100 shares of AOB at 750.00 for a gain of 750.00+25 = $775.00 or 775% in 18 months or 516% annually.

RISK
If AOB is < 7.50 come Jan 2011, then i will be put another 100 shares at 750.00, then i will own 200 shares of AOB at 750-25.00 = 725/200 = $3.63/share. this is less than your recommendation of 3.98/share. i think this would be a good trade for an 18 month span.

Due to my limited funds <<<<<25... i can probably afford to risk these small funds to this type of trade. but i see nothing wrong with your covered call when it comes to a return like that on 250g's, that to me is excellent.

Please let me know if there is a flaw to my trade, maybe i missed something.

May 28 08:12 PM

[Venu:]

Even though you get $4 for shorting the put, you need to keep the margin on the account.

Second, who knows like many good stocks have done in the past, if this stock falls to say $2 on Jan 1 2011, then you are stlightly over $300 in loss.

The return might look good, but in covered calls, you still have a chance of making loss, if the stock goes below cost price. At that time, you would wish you invested in a CD.

May 28 10:53 PM

[Jason Tillberg:]

1. There are already over 2000 January 2010 5.00 call contracts outstanding and it looked like 470 contracts traded yesterday. There should be enough.

2. The idea of this is for sound monthly income. 8 months is not a long time and rather than sell monthly calls, which is also very valid and to be honest, for my own account, I have June and July 5.00 calls right now on my position. The reward might be better doing so, but the risk is higher. Say it goes to 3.50 a share . The coming months 5.00 call I may only get 5 cents or 10 cents at most and not be able to sell 1.00 worth of premium by October. Of if it goes over 5.00, I'm out and have to employ funds in another investment or leave in cash at .25% annual yield.



On May 29 12:04 AM juan77 wrote:

> Sounds like a good idea. A couple of observations:
> 1. AOB is a small cap with a light volume. I don't know how easy
> it would be to sell 550 contracts of this stock.
> 2. 8 months is a life time in this macro economic climate and who
> knows where things will be 8 months later.If you can find a brokerage
> that offers cheap commission rates for Options(perhaps just a flat
> rate Vs fee per contract), why not sell covered calls every month
> instead of writing calls for Jan 2010? This will allow you to reassess
> the risk every month and offers the flexibility to maybe move out
> to another stock if needed.

May 29 09:21 AM

[Fred Thomson:]

This is a great article. As a long term covered calls trader, I can see the benefit of selling OTM calls on long term stock position. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at coveredcallcalculator.net

Jul 20 02:44 PM