Soaring oil prices, changing auto and truck markets and the tanking stock market have thrown thousands of stock pickers and long-term investors in General Motors (NYSE:GM) stock under a gas guzzling Hummer.
Although I have owned GM covered calls only since June 11, I'm one of the losers in the GM market. Millions of other long term investors have huge losses in the stock, compared with what I'm dealing with. I bought GM at $16.57 and at the same time sold GM July 17.50 call options for 96 cents. This put my breakeven at $15.61. The stock closed Thursday at $11.43 and the call options at 7 cents. So I've got a $3.29 per share, or 21%, loss on my trade. Annualized, that's horrible!
Why did I do this trade? I explained here. While I knew GM was in trouble and headed lower over the near term, I also knew that it was highly rated by Morningstar.com, which estimated its fair value at $27. Morningstar now has the stock "under review" for obvious reasons. It's assumptions have been thrown under the pickup.
Well, last anyone heard, GM's still paying a $1 per share dividend, which amounts to a 6.04% yield for me and 8.8% for those who bought GM at $11.43. So, if I collect the dividend for a year, my loss is reduced by a buck, assuming GM doesn't cut the dividend and the stock doesn't fall further. Both could happen. One reason GM has tanked in the last week is that analysts have determined it will need to raise capital. A dividend cut would be relatively cheap capital but would hurt employee and investors relations.
The July 17.50 (strike price) call options I sold a couple of weeks ago will expire out of the money on July 18. Then I can sell August 12.50 or 15 call options, depending where the stock is on July 21. I want to sell calls that are far enough out of the money so that there is little chance the stock will rise to the new strike price and be called, making me take my loss sooner than I want too. A call option with a 17.50 strike price gives the buyer of the call the right to buy your stock for $17.50 a share if the stock is trading at $17.50 or above. Indeed, my strategy is to collect the dividend and sell calls over the next couple of years. This would reduce my basis, or effective purchase price, and it would give the company time to begin to turn itself around.
Once investors see that a turn around effort is working, they will bid up the price of the stock, giving me a nice profit over the next two to four years, unless the stock is called prematurely. Thus my strategy for selling far out of the money calls. I'm speculating that GM can and will turn itself around with some help from gas prices, which I'm counting on going down. Congress is moving to limit the roles of pension funds, endowments, hedge funds and other financial speculators that have been inflating oil prices over the last two or three years. Some think that if their irresponsible speculative activities are curbed, oil prices could fall 50%. That would help GM's bottom line big time. I'm not that optimistic, because no one can predict what will happen.
Meanwhile, GM is shaking up its product line to meet the demand for vehicles that give better mileage. It could become a major importer of its smaller Opel and other high mileage cars it makes abroad. And it could and should reduce the number of models it offers, following the examples of Toyota, Nissan and Honda.
A company's success is 80% to 90% based on the business it's in and 10% to 20% based on management effectiveness. GM has been constrained by unions, legacy pension and retiree health care expenses, commitments to its thousands of dealers and suppliers and environmental laws. It's been virtually frozen in place. Now it's fighting for its survival, and a lot of those constraints have been and will be thrown under the SUV. Lots of workers and small business owners will be hurt while GM tries to satisfy consumers and environmentalists as well as shareholders.
The options markets are reflecting some optimism that GM will return to prosperity. Options that expire next January show that speculators think the stock will recover to between $13 and $14 before January 2009 options expire. January 2010 10 call options suggest the stock will recover to $14 before they expire while January 15 2010 calls show some speculators are counting on a rally to about $17. Bearish buyers of GM January 2010 15 puts, however, are speculating that the price will be under $10 a share when the options expire on January 15, 2010. As you can see, writing covered calls is a risky strategy, even when you buy stocks with high dividends.
Covered call trades limit profits, but not losses and require a trader to pay close attention to their positions. This strategy is not for passive investors. And there is absolutely no guarantee that my strategy for working myself out of this hole will succeed. I own GM covered calls. And I'm glad my position is tiny. I didn't bet the farm on this trade.
Disclosure: Author owns GM covered calls