Sequenom, Inc (NASDAQ:SQNM) is a ticker that I have covered in quite a few articles over the last year. The company is based out of San Diego, CA and has a market cap around $200 million. I currently hold and plan to continue holding a significant position in the company as I believe in the long term prospects. As the stock has continued its downward trajectory, I began looking at ways to use the stock I am holding to generate income to offset some of the downside. I came across a couple option contracts that offer a significant return at current levels. As I currently hold a full position in Sequenom based on my portfolio, I decided to look for covered call contracts that offered my level of return. For investors new to options, writing covered calls is
an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.
Some people may question why I am trading option contracts on a stock that is trading sub $2 as the fees associated with the option contracts can be significant. My response is anytime I can generate over 20% annual return using an option contract, I don't mind what the associated security is trading at.
I have two main criteria I use before considering writing covered calls against holdings in my portfolio as option contracts do carry a certain risk associated with them.
- Am I planning to hold the security for the length of the option contract? As I am usually purchasing shares in companies that I plan to hold for significant portions of time, this is usually not a concern.
- What are the short term catalysts that could alter my plan? This can be a little more difficult and usually results in higher option premiums and will be addressed below.
As of the market closing on January 29, 2016, Sequenom, Inc was trading at $1.61 and has seen a high of $4.80 and a low of $1.10 over the last year. The stock is generally volatile which if an investor can stomach it usually leads to higher option premiums. As the following is scalable based on the number of contracts a person is able to write, I will use a round number of 10 contracts for the example. As I have seen option contracts range in price, I will just use a $10 flat rate, plus $1 per contract, so this would cost $20 in broker fees, which I believe is fairly average.
The two covered call option contracts that have caught my attention are the June 2016 $2 covered call and September 2016 $2 covered call. First let's dive into the June 2016 covered call.
June 2016, $2 call
An investor with 1000 shares of Sequenom would currently have $1610 invested in the company. The June 2016 $2 call contract last traded at $0.20/share or $20/contract. Writing 10 covered calls would generate $180 in option premiums ($200 premiums - $20 broker fees). Based on the $1610 invested and $180 premium, this transaction just generated an 11.2% return. If Sequenom continues trading under $2/share as of June 17, 2016, no shares trade hands and the contracts expire. If Sequenom rallies above $2, the shares would be called away at a price of $2/share. Based on that, the investor would collect $2000 (1000 shares x $2/share) in addition to the $180 in premiums for a total return of 35.4% in just under 5 months.
September 2016, $2 call
A second appealing call that has a little longer timeframe, therefore offers a little higher premium is the September 2016 $2 call. The September 2016 $2 call last traded at $0.30/share or $30/contract. Writing 10 covered calls would generate $280 in option premiums ($300 premiums - $20 broker fees). Based on the $1610 invested and $280 in premiums, this transaction just generated a 17.4% return. If Sequenom remains trading under $2/share as of September16, 2016, no shares would trade hands and the contracts expire. If Sequenom rallies above $2/share, the 1000 shares would be called away at a price of $2/share. The investor would collect the $2000 (1000 shares x $2/share) in addition to the $280 in premiums for a total return of 41.6% return in just under 8 months.
The contract I would recommend is based on broker fees. If the broker fees are lower, I would go with the June 2016 calls as the investor could write more contracts over the course of the year and generate more income in premiums. If the broker fees are higher, then writing covered call contracts for longer duration usually works out better as the broker fees make up a smaller percentage of the premiums.
Compounding the Premiums
As I plan to continue holding Sequenom due to my belief's the company is significantly undervalued, I have been reinvesting my option premiums into Sequenom. By doing this, I am able to continue increasing my holdings without committing and new funds. Using the previous example of the June 2016 $2 calls, I would have generated $180 in premiums. Based on the $1.61/share price I can take by an additional 111 shares (may differ based on trading fees). By doing this, when the contract expires in June, if the shares were not called away from me, I can now write covered calls for 1100 shares. This works in the same way as reinvesting dividends, however, the dividend yield would need to be north of 25% to match the option premiums generated in the two scenarios presented.
My Only Hesitation
My only hesitation with doing this is the risk that Sequenom comes out with some news that sends the stock skyrocketing well above $2. As I have covered calls that will put a ceiling on my sell price at $2, I would miss out on that jump. For a small biotech company, that is a legit concern as I have previously written. The company pre-announced Q4 2015 results, which alleviates some of the concern for me as the results are right in line with previous results and should not cause a jump in share price. Considering the potential share price jump, I write covered calls on about half of my shares in order to get the best of both worlds. I can collect option premiums on about half of my holdings and in the event that Sequenom's stock shoots up, I still have half of holdings to collect the share price appreciation.
Disclosure: I am/we are long SQNM.
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.
Additional disclosure: In addition to my long position in SQNM, I have written covered calls against half of my position following the aforementioned strategy. This analysis offers up opinions of the author and are not recommendations to either buy or sell any security. Options carry additional risks, please remember to do your own research prior to making any investment decisions.