Seeking Alpha
What is your profession? ×
Profile| Send Message|
( followers)

If you read the first part of this article, you will know that using covered calls on stocks that behave similar to Sirius XM (NASDAQ:SIRI) can be both profitable and advantageous to the smart investor, as long as you are bullish on the stock. One of the disadvantages to writing covered calls against shares you own of a stock you are bullish on is if the share price greatly exceeds the covered call within the option time frame.

For example, take a look at the chart below:

Click to enlarge

That was a chart I used in part one of this article, showing three month gaps with no significant increase in the share price of Sirius. Those were perfect opportunities to write covered calls against your position that were above your share value and your cost basis. Now below has a highlighted section of when the strategy would not work for you:

Click to enlarge

Let's say for example in March 2011, you purchased 5,000 shares of Sirius at 1.70 per share which gives you a $8,500 cost basis. And let's assume you followed the strategy from the last article and wrote May 11 2.00 covered calls against all of them. Your premium may have gotten you a max of around $0.10 a share for a $500 gross.

As you can see from the above chart, the stock catapulted all the way up to $2.35 on or around settlement date (the date is irrelevant for this possibility because if you just held the shares, you could have waited and sold before or after the date and the stock stayed above the $2 threshold for all of May).

So, lets look at both possibilities and the financials:

Buy 5,000 shares at $1.70 = $8,500 Cost Basis

Sell 50 options = 5,000 shares for $500
Options called in May at 2.00 a share = $10,000

Total $10,500 for a $2,000 profit

Buy 5,000 shares (same cost basis)
Sell 5,000 shares at peak May price of $2.35 = $11,750

So this system would have cost you $1,250 in profits on this trade.

This was a rare example of when you are bullish on a stock how a large jump can hurt you. So how can you hedge against this?

Let's look at a present day example of a trade that can hedge against a huge gain:

Purchase 5,000 shares of Sirius at $2.16 a share = $10,800 CB
Write 50 June 2.50 covered calls against those shares for .10 a share which gets you $500

Purchase 50 Jan 13 2.50 options at .20 a share costing you $1,000

Huh? you may be saying, how does this help? Keep in mind again, this strategy should definitely not be used UNLESS you are very bullish on the stock. If you have any doubts about an immediate large giveback, this is not the strategy for you. So, why does this work?

January is a long time off: The reasoning for writing the covered calls against your position is to make some money while you hold the stock. June 15th is less than four months away, so you are hoping Sirius does not have a huge boost like it did in March/April of 2011. Let's assume it doesn't grow at that rate but stays in the $2/10 to $2.20 range. You will make the $500 free and clear and still have a chance to hit your $2.50 mark in Jan 2013.

Don't be a hoarder: Let's assume the stock grows to $2.35 a share by the time June rolls around. Noone says you need to keep the options you bought for Jan 13! An increase to $2.35 probably (even with losing four months time) will drive the Jan option price to at least $.25-.30 a share, you can take your profits right there (if you choose) and you still own your shares, the covered calls expire worthless, and you get $500 from the CC's and a few hundred more profit for selling the Jan options. More importantly you still own the stock and are free to do this again.

Win Win, I'm all In:

If the stock does reach and exceed the $2.50 before June, you make around a 15% profit on the called shares, and the premium for selling the calls ($500).

For the example below let's say $3.00 is where it closes on June 15th (expiration day):

If you bought 5,000 shares today then sold at $3.00 only:
$10,800 Cost Basis
Transaction = $15,000
$4,200 Gross Profit

If you bought 5,000 shares, wrote June covered calls at $.10 each
$10,800 Cost Basis
Called Shares Sale = $12,500
Premium for writing covered calls = $500
Transaction = $13,000
$2,200 Gross Profit

What if you bought 5,000 shares, wrote covered calls against them all AND bought 50 Jan 13 2.50 options?

$11,800 Cost Basis (5K shares at 2.16 a share and .20 X 5,000 shares = 50 Jan 13 options)

Called Shares Sale = $12,500
Premium for Covered Calls = $500
Estimated Value of Jan 13 options = .70 a share (being conservative here) = $3,500
Total Transaction = $16,500
$4,700 Gross Profit

As you can see, there are many ways you can incorporate different strategies into being a bull on a stock similar to Sirius. I tend to like to use the last strategy but that is just me. We that own the shares need to generate income from owning them. Don't wait on the share price to increase or buy only stocks that pay dividends, make extra money for yourself.

Disclosure: I am long SIRI.

Additional disclosure: I have recently liquidated my position in AAPL