Shawn Gray's  Instablog

Shawn Gray
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I have been a multi million dollar business managing partner for 14 years. Within that time I have also been very involved and focused on the market. I have weathered the storm through the technology bust of the late 90s and the banking crisis of 2008. Through the time my investment thesis has... More
  • High beta covered calls..do you have the stomach? 0 comments
    Nov 8, 2011 7:56 PM

         One of the most popular ways to generate a consistent revenue stream is option covered call writing.  In short covered call writing is purchasing a given security and making a bet that it will increase in value over time. These calls are purchased in share lots of 100 and a premium is payed to the holder of the stock for a future strike price.  In essence you are paid by another investor who does not hold shares to call your shares at a future price that they are paying the premium for. These options are available each month and expire on the third friday.  For instance stock xyz trades for 20 dollars and you by 100 shares spending 2000 dollars.  Your write a covered call one month out at a strike of 21 and a premium of .50 cents.  For that you will be payed 50 dollars.(100 shares x .50)  Your average share price is now reduced to 19.50 because of that premium.  If the share price reaches 21 your math is as follows: (21-19.5)/19.5= .076% return.  Not a bad return for 4 weeks work if your trade executes as planned.
        However, if you have the stomach and the timing to do this with high beta you can lock in some great gains and protect yourself against the innate volatility that these stocks bring.  What is beta? Beta is the implied volatility of a given security as it relates to the broader market or the S&P 500 unless otherwise specified.  The S&P has an implied beta of one so if a stock trades in a pattern higher or lower than the regular movement of the market it increases its beta or more simply its volatility.  These stocks can have massive moves to both the downside and upside but offer much higher premiums and returns in call writing than their low beta counterparts.  If you can catch these securities at the right time you can generate some very above average returns every 4 weeks with covered calls.  This strategy typically works best in a bull or rising market and I would not recommend it in a falling climate.
        Some of my favorites right now are PCX, LVS, and URI.  These three securities have had wild swings in the market from the peaks of the mid 1300s down to the sub 1100 range and back up again.  For example: PCX on August 1st traded at 18.80 while the S&P traded at 1286.  On October 3rd the S&P traded at 1099 or a 14.5% decrease while PCX traded at 7.17 or a 61.86% decrease!  Between October 3rd and November 8th the S&P recovered to 1258 or a 14.50% increase while PCX recovered to 12.00 or a 67.36% increase! URI following the same pattern had a decrease of 29.13 and a recovery of 35.02% and LVS a decrease of 23.47% and an increase of 28.25%.  That is enough to make your head spin. 
        Finding the right purchase times for these securities early in a month will give you time for price appreciation as well as covered call writing opportunities to generate a revenue stream and protect the downside.  Yes as you may ask covered call writing does limit the upside however it gives downside protection in volatile names such as these.  The beauty of the game is it rolls every 4 weeks.  You don't have to bet every time.  If you don't see what you want or what you like than you can always wait.
       For instance.  If you were to purchase 100 shares of PCX today at 12 and sell the December 13 calls for .85 your average price would be 11.15. If called your math would be (13-11.15)/11.15= 16.59%.  Not to shabby for 5 weeks work. At the same time because of the increased premium of the high beta your downside protection is almost 7% before you incurred a loss.  LVS trading at 48.03 and December strike of 50 at 1.83 gives you an average price of 46.23. Mathematically (50-46.23)/46.23=8%. URI trading at 25.40 and a December strike of 27 at .90 gives you an average price of 24.50. Mathematically (27-25.40)24.50=10%. All of these securities offer great short term returns.
        Ultimately the question is do you have the stomach for high beta returns.  If you do you might want to get used to a few high beta losses; and they can sting.  You have to develop a thesis of timing that works for you and makes you feel comfortable.  Set your parameters of gains and losses and stick to them. Never chase a stock and never chase the market let both of them come to you.


    Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in URI over the next 72 hours.

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