In a previous article I detailed how one might increase the amount of cash flow they received from holding Exxon Mobil (NYSE:XOM). Here's the basic idea: sell a covered call. By selling a covered call you're making an agreement to sell your shares at a given price in the future. The buyer gets the right, but not the obligation, to buy shares in the future, while the seller gets an upfront premium for something that may or may not eventually be worthwhile.
In the previous article I detailed the January 20th 2017 call option with an $87.50 strike price and a $3 premium. This could nearly double your expected cash flow from holding Exxon Mobil or else provide a 16% to 20% annualized gain. Yet this is only one alternative out of many. For this commentary I'd like to highlight additional options to give you a better feel for the scope of what is out there and also to provide a means by which you might judge whether or not this avenue is worth learning more about for your personal goals.
Here's a look at various January 20th 2017 call options currently available:
Constructing this sort of table can give you a great deal of insight as to whether or not selling covered calls is of interest to you. If you don't believe in the company naturally you wouldn't be holding shares, so this wouldn't apply. If you do own shares, this set of numbers can be telling.
In the first column I have listed strike prices available for the January 20th 2017 call option. These are the prices at which you can agree to sell, using "round lots" of 100 shares. Note that selling a call need not be "out of the money" or above the current strike price. You can agree to sell at a price below today's, and would receive a higher premium for doing so.
For the "net" premium, I simply used the most recent bid and reduced this by $0.25. This accounts for transaction costs, potential assignment fees and / or room for fluctuations. Both the premium yield and the agreed gain are without dividends. If you held shares and sold a call option available to be exercised in a year, it's conceivable that you would receive dividend payments along the way. However, I have not made that assumption here - erring on the side of caution and demonstrating what is occurring with the option only.
The first thing to notice is the inverse relationship between the "extra" yield you can receive and your total return. A lot of people don't pay attention to this, but you could get paid 8.6% on the current price for holding shares of Exxon for the year. If you also collected the dividends this would bump up to a 12% cash flow yield. Of course there are drawbacks. On a total return front, the share price could decrease by more than the dividends and option premium. Yet that's not a huge issue if you plan to hold shares anyway.
The larger issue is that in order to get this large cash component you have to agree to sell just below today's price. You receive the 8.6% premium, but this is effectively your capped out total gain (plus potential dividends) as well.
This works great if the share price declines further. If instead it jumps up 20%, you might be kicking yourself. It all depends on your underlying investing goals and which situations you'd be content with. For instance if you're happy agreeing to 12% gain, you could add a 5.7% yield to go along with potential dividends. If you require a 26% gain before you'd part with your Exxon shares, you could still add some premium income but it would only be about 1%. And if you'd only be happy to sell your shares at a 50% higher price, you could be out of luck, premium-wise. The above table gives you some context as to what is being offered on a year-out basis (naturally shorter-term options offer different prospects).
Incidentally, this sort of exercise works on the buying side as well. For instance, perhaps you have some funds set aside to purchase 100 shares of Exxon Mobil. You could simply input a buy order, or sell a cash-secured put at a price you'd be happy paying. Here's what that could look like with puts and the same January 20th 2017 date:
Instead of the strike prices being the price at which you'd be happy to sell, the values in this table indicate the price at which you'd be happy to buy. The "net" premium is calculated the same way, using the recent bid less $0.25. The premium yield indicates the amount of cash that you would receive based on the total amount that would be required to set aside. So for instance, $99 based on having to set aside $5,000 for the $50 strike and so on.
The agreed discount is how much below the current price you are willing to own shares. There are a couple ways to look at this: you could incorporate the premium into the cost basis (as is the case for tax purposes) or you could treat the agreed discount and the premium received as two separate possibilities. I have elected to use the second way, as it describes the process a bit more clearly.
For instance, with the $50 strike price, you are agreeing to set aside $5,000 to purchase 100 shares of Exxon Mobil in the next year. For that agreement you will immediately receive ~$99. If the shares are put to you, your cost basis would be the strike price less the premium. If the shares are not put to you, you simply keep the premium and the cash you set aside is the same and no longer tied up. In either instance you receive the premium, but you don't always get the shares, which incidentally is a main risk involved with selling puts instead of buying shares outright.
Note that once again the premium yield and agreed discount work inversely. This makes sense: the lower you're willing to buy shares, the less someone is willing to pay for that option. I could agree to buy shares of Exxon Mobil at $2, but this is a very small likelihood and thus I don't get paid much (or anything) for that offer.
Once again you have a table that can help illustrate the process. If you're happy to own at the current price, you could sell a $77.50 put and receive a cash flow of nearly 11% upfront. With this one of two things happens: either the option is exercised or it is not. If it is exercised, you get the shares and keep your premium. As you're willing to own shares at today's price, the premium is a bit of bonus (which could be reinvested or used immediately). If it is not exercised, you still keep the premium but you would not own shares. If the share price were to subsequently increase 20%, you'd miss out on that gain and be "stuck" with your 11% immediate cash flow to go along with your set aside funds.
In short, working through these types of scenarios can give you a better feel for whether or not selling options might work into your particular investing strategy. If you're happy to sell at a 10% or 20% higher price, covered calls can provide an immediate yield boost. Alternatively, if you'd happy to buy at today's price or even well below you can get paid for doing so. In both instances there are risks involved (namely capping your gains or missing out on ownership) but depending on your goals each can work as a nice portfolio supplement.
Disclosure: I am/we are long XOM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.