I place the word “option” in quotes above because many investors’ eyes glaze over at the thought of writing options, thinking it far too complicated a process. In fact, when we sent a version of this article to some of our higher-net-worth clients, one of our favorite clients wrote back simply: “My head hurts!” So if you think of the word "option" as a synonym for “alternative” and keep an open mind, it may help!
In fact, a call-writing program can not only place you more frequently on the side of the angels, it can mitigate the risk you take in deciding where and how to earn your steadiest returns.
A buy/write strategy such as the one I suggest for your own due diligence consists of the purchase of a stock we’d like to own and the simultaneous sell of a call option which gives someone else, in exchange for paying an up-front fee to us (called the “premium”, the right to call away our stock up until a certain time for a fixed price.
Silver may be an excellent hedge against a devaluing US dollar or a declining US stock market. Plus, it is one of the clear choices when viewing the current sandbox squabble taking place in Washington DC. These factors have made it quite the darling of the financial press and private investors these days. That gives it the volatility that results in high option premiums.
As importantly, I like the fundamentals under-pinning silver. So I researched all the silver stocks, ETFs and ETNs that had options on them and concluded the following one fits what we're trying to do to a "T". It was actually recommended, in the midst of my research, by one of my frequent financial correspondents, a friend whose financial savvy I hold in the highest regard.
The ETF I selected, ProShares Ultra Silver (NYSEARCA:AGQ), is heavily traded but its options are thinly-traded, so we have had to move very slowly as we acquired this position. The most we paid during our acquisition period (and still available today) was a "net debit" of $152. That means, after accounting for the premium we received, we effectively paid $152 per share for the ETF.
We use the term "net debit" because, whether we pay $220 for the ETF and receive $68 for the call we write, or pay $224 for the ETF and receive $72 for the call we write, we still pay an effective price of $152 for the ETF. (And trying to buy the ETF in a fast market, then sell the call, or vice versa, often gets you out of whack with what your goal is -- to get the maximum return while ensuring the best nights' sleep during the holding period.)
In this case, we bought AGQ at various prices hovering around $220 and wrote the AGQ January 2013 "250s" at prices around $68. An AGQ Jan 2013 “250” gives the call buyer -- the person to whom we sell the call option -- the right to call AGQ shares away from us at a fixed price of $250 for the next 18 months.
So what is our safe zone and where do we begin to incur risk? Well, of all the possible outcomes, we are profitable anywhere between an AGQ stock price of $152 and infinity, with maximum profit and continuing opportunity when AGQ closes on January 19, 2013 (the day the option expires) at exactly $250.
Why $250? Because that is the point at which we enjoy our maximum profit on the trade and we get to continue holding our AGQ! Above that price, we still enjoy our best profit, but we have our stock “called away” from us. Below $250, we will have made a slightly lesser profit – but will still own our original number of AGQ shares.
Since we paid in this instance $220, at an expiration price of$250 we would have gained $30 a share, a roughly 14% profit in 18 months for holding the stock. But since it isn't worth it to the option buyer to exercise an option to buy something at $250 that can be purchased outright for $250 anyway, we get to keep 100% of the shares as well as our $68 per share premium. Our maximum profit if the ETF closes at $250 is thus $98, or 45% in 18 months -- and we still own an ETF we like enough to write an option on yet again. (When it works like that, this seems almost too easy -- but of course it seldom works exactly like that!)
Our return diminishes to zero as AGQ reaches the lower margin of $152. If it closes anywhere within the range of $152 to infinity, we make a profit, however. At a price for AGQ of $175, for instance, we would be down $45 a share on AGQ ($220 minus $175) but would still have that $68 premium "cushion.” (Again, the option holder would not find it profitable to call AGQ from us at $250 when they could simply buy it for $175.) At a price of $175, our net would be just $24 ($68 in premium minus the $44 decline in the underlying stock.) Of course, we still own our AGQ. And if we liked it enough to own it at $220, we're still way better off than if we had just bought it there without selling a call.
At any amount above $250, we make only the difference between $220 and $250 ($30). We also keep the premium of $68. If the ETF goes to $350, $450 or $550, too bad, so sad: we make the same $30 plus $68. The person who bought the option, in exchange for their willingness to pay $68 a share for the right to call it away from us, gets all the reward from $250 to $350 or whatever. This is still quite profitable to us, both in dollars and in nail-biting psychic trauma -- we have lowered our risk in the stock by receiving a $68 per share in premium income but also lowered our "potential" for greater reward. Personally, I’d rather lose a little opportunity – that just means less bragging rights at a cocktail party – than lose actual money. That hurts.
Where do we actually begin to incur a loss on the position? And at what point do emotions overrule the rationale of our original purchase?
If we bought the ETF outright at $220, and didn't write a call option on it, we'd be looking at a $1 per share loss at $219, a $10 per share loss at $210, and a $50 per share loss at $170. A $5,000 loss per 100 shares can shake the confidence of the most adamant silver bull. This leads to whipsaws as the emotion -- fear of dollar loss, spousal respect, self esteem, etc. -- overpowers the original logic of entering the position.
By writing the call option, even if the ETF were to plunge to $170, we don't reach the emotional trauma level. Our decision is, do I take a disappointing $18 a share gain (the $220 we paid for the stock less the $68 we received as a premium gives a net price of $152) after all this time, do we risk riding it down, or do we write another call against it? Any of the three alternatives are better than staring at a loss…
A controlled option writing program involves keeping an eye out for the best situations, doing the research, and minding the store. And it can still result in lost opportunity on the upside and actual loss on the downside. But it can also provide a steadier stream of cash flow and, every bit as important, remove a good deal of the emotion from our investing. This particular buy/write gives us a hedge against uncertainty and one in which I am willing to give up the “possibility” of big returns in exchange for what is, to me, the greater likelihood of a merely exceptional return.
[A note to sharpshooters: I have tried to make this as straightforward as possible to help the greatest number of readers. Some degree of thoroughness (or trips into the weeds, depending upon your perspective) will inevitably fall short for some. I am a Registered Options Principal; yes, I understand that one can also drop one leg early and re-initiate or not, close the entire position prior to expiration, calendar spread it, ratio it, collar it, etc. May I suggest that an insufferable need to show one’s knowledge of such matters here will only confuse those for whom this might otherwise be a good initiation. There are wonderful blogs on Yahoo and elsewhere at which true devotees can squabble or pontificate for weeks about the best strategies!]
Disclosure: We, and/or those clients for whom it is appropriate, are long AGQ and have written the $250 AGQ January 2013 calls against our holding.
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
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