The option strategies discussed here extend the discussion on covered calls, initiated in our article earlier this week. They present ways to enhance or recapture a return on stock you already own (underlying position), even if that stock is showing a loss in your portfolio.
The stock enhancement strategy can be used to greatly improve the return on a stock that you own. This is an options strategy that can be implemented at no additional cost beyond the original expense stock ownership. It also has no margin requirement and hence can be done in a retirement account. This strategy can be viewed as an extension of the covered call concept, although the motivation and time frame for the trade are unlike that of the typical covered call.
The same strategy can be used to accelerate the recovery in value of a stock that has suffered a significant drawdown. In this case the strategy is known as the stock repair strategy. Again, it is a no cost trade.
Stock Enhancement Strategy
For this strategy to work, it is necessary for your stock to make some reasonable gain over the next 5-6 months. This strategy is intended to convert a reasonable profit in the stock into an excellent overall return at no cost beyond what you paid for the stock.
For each 100 shares of stock, the basic plan is to sell one out-of-the-money call with a strike price at the level you expect the stock to reach in 5-6 months. This combination is just a covered call trade, except that it goes much further out in time than you would expect with a typical covered call. Next, you use the proceeds from the sale of the covered call to pay for a one contract bull call spread. The upper strike for the bull call spread will be the same as the covered call, while the lower strike for the spread will be nearer the current price of the stock.
Let's look at an example to illustrate the stock enhancement strategy:
Example: Many analysts are forecasting significant gains in the prices of copper and gold over the next 5-6 months. A good way to play this forecast is to buy Freeport McMoran (FCX), a strong company that specializes in both metals. To boost the return in this investment, the Stock Enhancement Strategy can be employed.
Trade: Buy 100 shares of FCX at $35.50 per share. Buy 1 Nov. 37 call for $2.3 per share and sell 2 Nov. 40 calls for $1.20 per share. The option transactions actually produce a net credit of $.10 per share to help pay for your commissions.
Position: This holding can be viewed as a covered call (long 100 shares FCX and short 1 Nov. 40 call) and a bull call spread (long 1 Nov. 37 call and short 1 Nov. 40 call).
Payoff: If FCX is above $40 at the November options expiration, the stock will be called away at $40 for a $4.5 per share gain over its purchase price. The bull call spread will be worth $3 per share. The total gain of $7.5 per share represents an excellent return of 21.1% on a stock that only needed to move up by 12.6%.
Comment: Remember that this is a no-cost trade. If FCX does not reach $40 by the November expiration, the Nov. 37 call will still provide a profit if the stock price exceeds $37. An additional bonus on this particular trade is that FCX pays a nice annual dividend of which about half can be captured over the next 5 months.
Stock Repair Strategy
Using the same approach as the stock enhancement strategy, it is possible to recover the full value of a stock whose price has suffered a large pullback. For the repair strategy to be effective, it is necessary for the stock to make some modest gain in the next 3-4 months.
Let’s look at an example to illustrate the stock repair strategy:
Example: Those who bought 100 shares of Facebook Inc. (FB) at $38 per share during its IPO in May are now looking at a deflated price of $31.70 in mid-June. With a modest increase in the price of FB over the next 3 months, the Stock Repair Strategy can more than make up for the lost value.
Trade: For each 100 shares you own, buy 1 Sept 32 call for $3.2 per share and sell 2 Sept 36 calls for $1.6 per share. This is a no cost trade.
Position: This holding can be viewed as a covered call (long 100 shares FB and short 1 Sept 36 call) and a bull call spread (long 1 Sept 32 call and short 1 Sept 36 call).
Payoff: If FB is above $36 at the September options expiration, the stock will be called away at $36 for a $4.3 per share gain over its mid-June price of $31.70. The bull call spread will be worth $4 per share. The total gain of $8.3 per share represents an equivalent stock price of $40.00, which is $2.0 per share better than the original purchase price.
Comment: Remember that this is a no-cost trade. If FB only reaches $35 by the September expiration, the Sept 36 calls will expire worthless and the Sept 32 call will still provide enough profit to effectively raise the stock value back to its original price of $38.