Most income investors are familiar with the strategy of selling “covered” calls against stock that they own as a way to generate additional income from a holding (assuming it is a dividend stock, otherwise the word “additional” does not apply). There are many resources available to an investor to explain the details of this strategy, so I will not go over that here. This article will assume the reader knows the basics of options and the covered call strategy.
What I will present is a “real-world” recap of my experiences selling covered calls against my holdings of Pfizer (NYSE:PFE) over the past two years, including all the relevant, painful details. I will offer my views of when the strategy is appropriate and how it should be applied by a conservative income investor. Finally, I will discuss what is meant by “pin risk” at expiration, and the possible exposure an option trader can have from after-hours trading on expiration Friday. Many option traders are not even aware that movements of the underlying stock price in after-hours trading on the Friday of expiration can cause the expiration results to vary 180 degrees from what they expect, based on the stock’s closing price at the end of regular trading. As you will see when I provide details of my recent trade, I suddenly developed a keen interest in these issues as I pondered what steps to take at 3:00 PM on Friday, December 16, 2011, regarding my December PFE option with a strike price of 21.00. (PFE closed at 21.03.)
Before I go any further, in the interest of full disclosure, note that I am not a financial professional nor am I certified in any way as a financial advisor. I am an independent, small investor sharing experiences that hopefully will be interesting, as well as helpful to others in similar circumstances.
I realize that by disclosing my actions at such a detailed level, I will lay myself out for all types of second-guessing and commentary. I will hold nothing back, even though the facts will likely expose my lack of sophistication as an investor. But that’s fine by me. I welcome the second-guessing and the commentary. I see it as my opportunity to learn from others and hopefully improve my investing performance.
First, to provide some background, I want to briefly discuss my approach to acquiring stocks and selling calls against my positions. If you want more detail, I provide a lot more about my approach on my blog, accessible by clicking on “Visit Optimum Stock Investing” under “about this author” in my profile data area shown to the left of this article. From the Home page of "Optimum Stock Investing", select (logically enough) "Approach" to see a menu presenting five essays detailing same. I will summarize the approach here.
Once I have researched and identified a stock I want to own, I first determine how many shares I want to acquire in total, such that the holding will be 5% or less of my total portfolio. In fact, I prefer only 2% to 3%. I then acquire the holding in no fewer than three incremental buys, stretched out over a time period than can be many months or even a year or more. I usually only buy subsequent positions if I can get a better (i.e., lower) price. Thus, I average down. I only consider selling a call (or calls, if I hold multiples of 100 shares) against the position when the stock has appreciated enough that call (or calls) are available at a strike that would yield a nice gain if the shares were sold, and the premium available is enough to make the trade worthwhile.
What I am looking for is a strike price less my average cost of shares that gives me a 15% to 25% gain, or at least $4.00 to $8.00 per share. Also, the strike needs to be at least $1.00 above the current market price of the stock, and ideally more than that.The option expiration should not be more than six months out, or nine months or so at the most. Finally, the option must be able to be sold for at least $1.00 or more. My fundamental approach is I “don’t let the option selling strategy tail wag the dividend stock holding dog”. Covered call selling is therefore an “add on” strategy, to be used only occasionally when everything lines up as outlined-- not something that has to be used on every holding at all times. Remember, you are not receiving very much in selling premium, so you do not want to set yourself up to forfeit a significant gain if you can avoid it. (Rest assured, if you sell covered calls for very long, this will happen sooner or later.) Selling calls should be seen as an alternative to selling the stock, and should only be considered when the market has gone up for a while, and is extended.
Now, let’s review how well I followed this script with PFE. I determined early on I only wanted to own 100 shares. The yield was great (back then), but there were some concerns over the drug pipeline and the blockbuster drug Lipitor going off patent in a couple of years, and whether the dividend could be maintained at the (then) lofty level. This was in March, 2008.
On March 28, 2008, I purchased 50 shares at $20.49, which seemed like a reasonable price, although definitely not a “steal”. Things went downhill after that, but I saw the decline as an opportunity to average down, buying 25 more shares on June 11, 2008 at $17.59. After that came the financial crisis. I held my 75 shares, but did not buy more through the depth of the crisis, even though I could (and should) have bought as low as $12.00 to $13.00. My excuse is-- at that point in the crisis I was able to buy companies that I thought were better investments than PFE at very reasonable, “Ben Graham margin of safety” level prices, so I didn’t want to spend my limited funds on PFE, especially after a 50% dividend cut (from $.32/shr to $.16/shr) that came in-between the February 2009 dividend and the May 2009 dividend.
As the market started to move back up and I acquired funds by taking some profits elsewhere (too soon, of course), I decided I had better buy another 25 shares to get to 100, so I could make up for the dividend cut by selling calls. I bought my final 25 shares on January 28, 2010, at $19.00, and on that same day I sold my first covered call against these shares for $1.00. The expiration was September, 2010, nine months out, and the strike was $20.00. The dividend was soon increased, first to $.18/shr, then later on to $.20/shr. That was it for the good news, as PFE dipped again in 2010 such that I was able to buy the call back early at $.02, in June, 2010. (One tenet of my option strategy is as follows: if I have a 90% or so profit and there are two or more months to go to expiration, better to close the position and suffer the commission than risk a reversal which gives back the gain.) I was considering selling all and taking a loss, but the dividend increase gave me a reason (excuse?) to hold on.
By March 2011, PFE was recovering, and on March 17, 2011, I sold another call at $1.00, with a December 2011 expiration and a strike of $21.00. PFE stayed comfortably below $21.00 most of the time after the option was sold, until option expiration week, when I began to suspect I might have to buy the option back if I wanted to keep the shares, which turned out to be right. I waited until the last hour on December 16, 2011, and closed the trade by buying the call back for $.10. I have gone through all these steps in excruciating detail to illustrate how “real-world” investing / trading can differ from the ideal script. Hopefully it hasn’t been too boring, perhaps even mildly entertaining!
So what were my results, and where do I go from here? The total cost of the shares (including three Schwab $8.95 commissions) is $1966.10. I have received $276.00 in dividends, and I have executed two option trades netting (after commissions) $76.43 and $68.49, for a total of $144.92. My total cash returned has therefore been $276.00 plus $144.92, or $420.92. I have held the stock for three years and nine months (45 months). By my “back of the envelope” calculations, my annualized return has been 5.71%. (I may not be calculating this properly, but this how I’ve always done it. See formula below.)
[[$420.92 / $1966.10] / 45 months] * [12 months ] = 5.71%
Not great, but better than money market rates over this time period, especially considering we had a little volatility here and there. The annualized return from dividends alone would have been only 3.74%. Options selling accounted for 34% of the cash received, even though I only sold options during the last two years of the three plus years that I have owned the shares. I made a number of mistakes and moves that weren’t well-timed, yet I still came out reasonably well. Plus, I still have the shares.
At this point, considering how PFE has been trading up lately, and perceiving that the business fundamentals and outlook seem to be improving, I do not want to let the stock go for less than $23.00 to $24.00. No options were available (at least not late on Friday, December 16, 2011) on terms that met my criteria, so I did not turn around and immediately sell another call. If PFE can rally above $21.00, or maybe even above $22.00, sometime over the next few months, I will possibly be able to sell another call on terms that I will find attractive. At least, that is my current thinking on how I hope to proceed.
To wrap up this post-mortem, I want to give every option trader something to think about that usually does not come up, but certainly did today (December 16, 2011) for traders on either side of the December 2011 PFE call at the 21.00 strike, if they did not exit their positions. What occurred was that PFE closed at $21.03, only three cents above the strike. This exposed anyone on either side of the option trade to “pin risk”. So what is “pin risk”? It is when the underlying closes very close to the strike, such that the parties involved cannot predict with 100% confidence whether the option will be exercised or not. The stock has “pinned” the participants “to the wall”, is how I see it. (Note: this colorful way of seeing this situation is my own invention.) The various brokerages have slight variations in their rules for assignment, but generally, for a call seller, if the stock closes above the strike, even if only by a few cents, assignment will occur. For a more detailed explanation of “pin risk”, click here.
But wait, there’s more (to borrow a phrase from the irritating, off-hours infomercials). Indeed there is more, there is another risk that many people are not aware of. Options assignment can be affected by after-market trading in the underlying that occurs after the close on expiration Friday. The options themselves cannot be traded after the close on Friday, but the option technically does not expire until 12:00 noon the following day, Saturday. The option owner holds the best cards here, he/she can elect to exercise the option (i.e., in the case of a call, buy the stock at the strike price) after the close no matter where the stock closed at the end of the regular trading session. The only requirement is that the holder must notify the brokerage by 5:30 PM on expiration Friday that he/she wants to exercise. If the stock closed below the strike, why would any option holder do this? The answer is, because of after-hours trading. If the stock should suddenly jump up in price in after-hours trade, the holder (who presumably has the type of account, etc. to participate in after-hours trading) can sell the stock (short, presumably) in the after-hours trading session, notify the brokerage to exercise, and thus pocket a “locked-in” gain.
Meanwhile, the option seller, noting that the stock closed comfortably below the level where “pin risk” could be expected to come into play, believes he / she is “home free” on the trade. Feeling in a celebratory mood after seeing the option that was sold expire worthless, he / she hops on his /her Harley-Davidson and cruises to a favorite “watering hole” to celebrate his / her cleverness, totally unaware that come Monday, he / she is going to be very surprised to learn the option was exercised and the shares are no longer owned. (Bear with me for this addition of a little color to an article that is a bit technical.) To read more about this, do an Internet search on the phrase “does after hours trade affect option expiration”, or something similar, you will find many articles out there on this topic.
Anyone who sells covered calls needs to be aware of these issues. You could go on for years (in my case, five +) selling covered calls without running into these risks, but when it happens, better to be informed than not.
There are a lot of things to consider in selling calls against your positions, but when it works, (to paraphrase a recent sports commercial), “it’s a beautiful thing”. (Perhaps I watch too much TV!)
Disclosure: I am long PFE.
Additional disclosure: This article is timely, based on my experience with calls on PFE that expired Friday that were very close to the strike. I believe it will be of interest to the non-professional SA readership that may not be aware of the unique risks of options that expire "at the money" Thanks.