Lately, I have been focusing on various ways that an investor could supplement their income by making agreements; that is, specifically by utilizing options. The idea is not to advise or suggest a certain strategy - I would never provide a blanket recommendation. Instead, the concept is to provide a sampling of what is out there. I present it as an opportunity to learn more about a given security and the alternative ways of owning or agreeing to own shares. Sometimes it might look attractive, other times not; the takeaway is enhanced awareness.
With that concept in mind, I thought it might be useful to explore some available options with Exxon Mobil (NYSE:XOM). Naturally, any number of securities can work for this example, but Exxon Mobil is quite well known and share price bids have been reasonably volatile as of late.
Over the long term, partnering with Exxon Mobil is a bet on continued energy demand and reasonable prices. More specifically, when partnering with Exxon Mobil you're assuming the company can sell its product profitably and abundantly over time. This isn't much different than say Hershey (NYSE:HSY) selling chocolate bars for a profit. However, it does take a bit more conviction in that Exxon Mobil's pricing is highly cyclical.
To this point, Exxon Mobil has certainly shown its might through the years. Along with a three decade-plus dividend increase streak, you have a company that generated $16 billion in profit last year despite a very challenging commodity pricing environment. Granted this a far cry from the $41 billion earned in 2011, but it remains that if you suspect that more energy will be used in the future, a company like Exxon Mobil has the ability to take advantage of this.
So that's the first test. You want to be happy to own shares from the start. It sounds so simple, and really it is, but a lot of people can get caught up in the types of deals that are being offered. No matter how enticing an option premium may appear, you always want to be comfortable holding shares of the company. There's a very real chance that you will start or end up owning shares, and you don't want that to be a downside. That should be a good thing.
So let's presume that you want to own shares of Exxon Mobil. You can go about this in a variety of ways. The simplest way to own shares is to do just that: buy shares. We'll keep it straightforward: with ~$8,100 to invest you could purchase 100 shares.
Naturally, you'd like to think about this over the long term. If I buy a house and plan to live there for the next 20 years, I don't care what you're willing to pay for it tomorrow. That's a liquidity bid that I am not interested in. However, in order to make a comparison to some alternatives, we need to look at some possibilities on a shorter time frame.
In this case, we'll think about what could happen through January of 2017. Exxon Mobil's current quarterly dividend sits at $0.73 per share, or $2.92 on an annual basis, prior to thinking about a potential dividend increase. So by owning 100 shares, you'd anticipate collecting $292 or more in dividends to go along with whatever happens with the share price. Here's a wide range of possibilities with corresponding gains:
Obviously, future share price bids outside of this range are conceivable, but this gives you a reasonably wide range. The dividend "protects" against a slightly lower price (as far the total return during this period is concerned), but in general, a share price less than $78 equates to negative return and anything over this mark would be positive. Keep in mind that you might prefer a lower price if you're a net buyer and do not plan to sell.
So this gives you a feel for what your return might look like in the coming 11 months if you elected to buy and hold shares of Exxon Mobil. Let's look at some more possibilities.
A separate alternative would be to both own shares and sell a covered call. It's covered because you own shares. Doing so would be making an agreement to potentially sell your shares at a given price in the future.
Let's work with some various call options that you could sell. For instance, you might be willing to sell your shares at say $85, $90, $95 or $100 any time prior to January of 2017. For making one of these agreements, you could presently receive "net" premiums (less $0.25 for transaction costs and fluctuations) of $4.90, $2.95, $1.64 and $0.78.
So, as a for instance, if you bought 100 shares of Exxon Mobil and agreed to sell at $90, you'd collect ~$295 upfront for doing so. If the option goes unexercised, you keep the premium and shares just as you had planned. If the option is exercised, your maximum gain is between 15% and 18%.
Here's a look at the potential gain from owning shares by themselves as compared to what your gain would be if you both owned shares and sold a call option:
This table strikes me as quite interesting. Selling covered call options never crosses the mind of a good deal of income investors. And to be sure, you can do just fine by buying excellent business, holding for the long term and never worrying about the extra work involved in making or not making agreements. Yet, here's a simple table explaining why obtaining a bit of awareness could be useful.
I have highlighted which security would provide the best gain for share prices ranging from $60 to $100. (In reality, it's $0 to $100, but I wanted to keep the table reasonably compact.) What's interesting to me is that there isn't one scenario between $60 and $100 where owning shares outright would provide a "better" return.
With owning shares, you get the dividend payment and whatever happens with the share price. By owning shares and selling a covered call, you get the upfront premium along with potential dividends and whatever happens to the share price up to your call strike price.
Note that after the strike price is received, the total gains in the above table for selling the covered call actually decrease. This may or may not be the case in practice. That assumes that you received the upfront premium and strike price, but not the dividend payments. In reality, you could receive the strike price, upfront premium and dividends, but that's not yet known.
Let's compare owning shares to owning shares and selling the $100 January 2017 call option to solidify the illustration. You can see the potential returns generated by owning shares in the left column. By selling the call option, you would receive ~$80 upfront that is yours to keep. This happens regardless of the future share price movements. In addition, you continue to own shares and collect dividends just as you normally would.
So for any future price between $0 and $100, selling the call option is going to provide a better return. You're always going to be ~$80 ahead of just owning shares. A lot of people talk about the downside - call options do not prevent against loss. Yet, it should be clear that the downside is lower (albeit in this instance just slightly) to owning shares outright.
The true risk is seeing the share price increase above your strike price, say to $105. In this instance, you'd be "stuck" selling at $100 when you could have held on, forgot about selling a call, and held shares at $105. This is why it's important to be content with either potential outcome.
With the $100 call option, either your total return is greater than owning the shares outright or your gain is capped at ~28%. This is what you have to consider when you think about making a potential agreement. (There are other things like premium and share tax considerations, but this is the main concept.) And naturally there are other options out there with even higher strike prices.
This is how I'd go about considering whether or not a certain strategy may or may not be right for you. The first step is to find a business that you'd be happy to partner with. The order here is important: you don't want to go out and find an attractive premium and then be forced to own something you don't believe in. I used Exxon Mobil in this scenario, but it follows that you only want to make agreements for securities that you'd be satisfied with.
From there, I find it helpful to consider what types of agreements are available. Many investors never consider this step, but as illustrated above, it can potentially pay to do so. If you suspect that shares can increase 50% or would be unhappy selling at any price, this sort of thing isn't for you.
Alternatively, if you would be pleased with a 15%, 20% or 30% gain in less than a year, you quite literally have options available that would pay you to make those agreements. It's all about owning excellent businesses, figuring out your underlying goals and being aware if certain agreements can supplement those ambitions.
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.