Stock options are defined as the rights to either buy or sell an underlying equity in 100 share increments. Call options in particular are the rights to buy a particular equity. If the investor is long one call option (bullish), he has bought the right to buy 100 shares of a particular investment at a particular price up until a particular time. If the investor is short one call option (bearish), he will have sold the right for someone else to buy from him 100 shares of a particular investment at a particular price up until a particular time. These rights have value in themselves. For those who understand the benefits and disadvantages, such financial tools that derive their use from an underlying asset, offer the ability for investors to profit regardless of a market direction.
Investors looking to take protective stances in broad-based index funds may want to consider using an options strategy of selling covered call positions. This simple strategy has several unique advantages that offer an additional measure of protection for investors on the downside in exchange for some of the upward gain momentum that pure stock ownership offers. This strategy is best understood through an example. The following ignores commission costs for the sake of keeping things simple to understand:
- The current price (2/21/2012) of the SPDR S&P 500 (SPY) is $136.47, a price that Joe is currently willing to buy shares at. Joe buys 100 shares of the index fund and sells open one call contract with a strike price of $140/share for the underlying equity of SPDR S&P 500 . The expiration date he chose was for December 31, 2012. Upon completing this transaction, Joe spent $13,647 and immediately received $734 bringing down his total cost to $129.13/sh. By setting up this transaction, Joe now has 100 shares of SPY and an open short position for the call option.
If Joe does nothing for the remainder of the year, the following will occur:
- If the price of SPY on January 1, 2013 is below $140/share, Joe will keep the $734 and the short call position will close unexercised. Joe will still have his 100 shares of SPY.
- If the price of SPY on January 1, 2013 is above $140/share, Joe will sell his 100 shares of SPY for $140/share as the short call position will be exercised. This will force Joe to sell 100 shares of SPY for a profit of $353 above the point he was willing to buy the shares at capturing a 2.6% gain on the transaction. As well, Joe keeps the $734 he made for selling away the rights to his shares. Effectively, Joe will have made a total of $1087, a 7.9% gain.
Therefore, over the course of 9 months, Joe has either profited $1087 (7.9% gain) or he has bought shares for $7.34/share less (discount of almost 5.4%) than the current share price. Remember, this was a price he was willing to buy at anyways. When one contemplates the fact that the annualized return for the S&P 500 from January 1, 2000 to December 31, 2011 has only been 2.42%, this basic options strategy shines quite brightly. Not only did the strategy beat the market in the past dozen years, but more importantly, it did so irregardless of the direction of the market.
There are several innate advantages that are inherently built into this particular strategy:
- Decay of Time Value. Much of the value of the transaction carries the time cost for the buyer of the option to use his right. Therefore, if SPY were to trade at the same price of $136.47 in say July 2012, we would expect the value of the short position to be significantly less than it was in February, which is advantageous to the covered call holder.
- Buy Back Capability. All options of a similar nature are considered equal and able to be offset. Let us pretend that SPY dropped to $125/share in March. Joe will likely have seen his short call position in the transaction drop a significant amount to around $3 from its original $7.34. Instead of waiting until January 2013 for the transaction to pan out, Joe can take profits now if he so chooses to do so by "buying to close" the position at the current market price for the option. In doing so, Joe will still have shares at a price he was willing to originally pay, but he has also gained a theoretical $434 during a time in which the market was trending downwards. This also frees up Joe's ability to reset the covered call strategy again when and if he so chooses to do so at a later time.
- Pricing Control. The strike price of $140 was just a target that was chosen to incorporate additional gain should the shares get exercised. However, options permit investors to set their own strike prices and let the market decide their worth. Call writers also have the ability to set their expiration times and allow the market determine the value as well. Unlike an equity position, options come with the ability to choose values at which to operate, thereby offering unique positioning capabilities.
- Lower Entry Costs. By using this covered call strategy, investors can lower their cost of entry into the underlying equity position. This is because the call writer collects the premium which is essentially a deduction against cost basis of the shares. As a result, the investor can guarantee a lower cost of entry than the current price.
- Cash Up Front. Cash now is better than cash later. By selling a covered position, the investor gets cash in the beginning of the transaction, which could be used to gain additional interest elsewhere. As previously mentioned this upfront payment essentially acts as a lower entry point into the equity position.
In some respects, setting covered calls is an effective way to create your own "dividend" yield while settling for a stable return. In light of this, investors should view a covered call less as an equity investment and more of an income asset. By meddling with the time and strike prices, an investor can actually do quite well, especially when one adds up the benefits of several short-term gains from collected premiums. The inherent risk of the covered call strategy is the chance of losing out on the upside potential of the underlying stock. Yet should an investor fear getting his shares exercised, he even has the flexibility of buying back his covered call only to set it out at a further expiration in order to catch a higher premium than the one he bought back.
It is critical to remember that options work most effectively when there is an active market open to investors. Popular ETFs provide inherent stability while offering a large enough trade volume to effectively enter and exit a given option position. New investors to options in particular would do well to avoid popular leveraged ETFs such as the ProShares Ultra QQQ (QLD) or the Direxion Small Cap Bull 3X Shares (TNA). As the trading action is already more volatile when one uses options, the additional volatility in a leveraged fund like QLD or TNA may be a bit reckless. The following list of ETFs are ideal underlying assets for which to establish covered call positions. These funds are chosen as they reflect the broad based swings of the market as a whole. Current prices and the last available expirations of these options are noted as of February 21, 2012.
|Fund Name||Last Price||Last Expiration|
|iShares Russell 2000 (IWM)||$82.23||Jan. 17, 2014|
|PowerShares QQQ Trust (QQQ)||$63.61||Dec. 19, 2014|
|SPDR Gold Trust (GLD)||$171.02||Jan. 17, 2014|
|iShares MSCI Emerging Markets Index (EEM)||$43.75||Jan. 17, 2014|
Additional disclosure: I have various options both long and short open in IWM and SPY.