Owning a stock and selling a call option on that stock can be a good way to increase the yield of a portfolio or mitigate the effects of small down-moves in stocks. Unfortunately, this strategy does not completely protect against catastrophic downdrafts in a stock price because the call writer only receives the premium for the call option she wrote. All further down-moves are unprotected.
As with everything involving options (maybe life too), there are tradeoffs: in exchange for the higher yield, a covered call strategy limits potential gains to the strike price plus premium received. For example, if I buy XYZ for $10 and write a call option struck at $11 for $0.20, the most I can make is $1.20. Since this strategy exposes investors to a total loss of their investment, it is not good for stocks that may have dramatic down-moves; that being said, I think this is a great strategy for stocks that have limited downside, due to their strong financials, and slow and steady upside potential, so that the option writer’s calls expire worthless every month and the process can be repeated month after month.
Three stocks that I think are great candidates for this strategy are Microsoft (MSFT), Intel (INTC), and Nokia (NOK).
Microsoft
Microsoft seems like it has been stuck between $23 and $30 for ten years. In that time period, earnings have grown dramatically, their products have become less stylish, investors have become increasingly frustrated with management, and they beat their earnings estimate almost every quarter. MSFT trades at 9.2x’s this year’s expected earnings, and 8.5x’s next year’s earnings .MSFT also has a tremendous cash position, free cash flow, and a respectable dividend that reduces downside in the share price.
With shares currently trading at $23.70, I think MSFT is close to bottoming and will slowly move back up to $30. One can sell the 24 strike calls expiring in July for $.47. If I am correct, and MSFT does not go below $23, the most one can lose is $.23 with the high probability of making $.77 in one month. With any luck, when options expire in July, MSFT will be slightly below $24 and the process can be repeated next month. I initiated this position on Friday.
Intel
INTC is very similar to MSFT in that it has been stuck in a trading range between $19 and $25 since 2003. In that time, earnings have grown significantly, the company has built a huge cash cushion, and the dividend is near 4%. EPS estimates for 2011 and 2012 are $2.29 and $2.39 respectively giving a forward P/E of 9.33x’s 2011 and 8.9x’s 2012 EPS. I think the combination of low P/E, decent earnings growth, 4% dividend, and a large cash position limits INTC’s downside to $20. At the current price of $21.38, I think INTC could fall a little further before recovering.
My entry point for INTC is $20.50, at which point I will buy some shares and possibly overwrite some out-of-the-money calls on the position to increase the yield. One interesting fact about options is that buying the stock and writing a call gives investors the exact payout (assuming your broker pays interest on cash balances and put-call parity hold) as simply writing a put option at the same strike and expiration.
So if you find my INTC idea to be compelling, writing a $21 strike put will give the same payoff as buying the stock and writing a $21 strike call (assuming both put and call expire at the same time). The only difference will be that writing the put only costs 1 broker commission and the buy-write strategy involves two commissions.
Nokia
Nokia (NOK) is a different story than MSFT and INTC. This company has suffered some major setbacks lately, and in my opinion has no bad new left for the next 9 months. Also, I don’t see any catalysts to push the stock price higher anytime soon. So, I think NOK makes a good buy-write candidate especially because the implied volatility is near 50% for the near-term options.
I think NOK will not fall below $6 in the near term, so I would buy the stock today, and write a $7 strike call expiring in October for $.40. To lose money in this position, the stock would have to close below $5.92 when options expire in October which I think is unlikely, and the position can potentially earn $1.08 if NOK closes above $7 when options expire in October. I think the most likely outcome is that NOK closes October at around $6.50 and the options expire worthless yielding a nice return of $.40.
I own NOK and I plan on selling the October 7 strike calls sometime this week.
A buy-write strategy can transform slow or dead money stocks into an investment with very solid returns. I think it is important to only use this strategy with companies with very limited downside because writing the call options removes the main reason for owning stocks - which is the unlimited upside potential. So I want to balance forsaking the upside with having a limited downside by investing in companies with strong balance sheets, solid dividends, and large cash balances.
