Author's Note: Premium Research Subscribers to Income From Covered Option Writing got an early look at this article.
Author's Update, January 19, 2016: Due to fast price and momentum changes at the open this morning (1/19/16), I was able to close my underwater position on the Feb. 2016 puts and do my buy-write using the covered calls contracts for 1/20/17 $100.00 @ $87.20 net debit. This is instead of rolling forward on the puts as described in the article body.
Not every train derailment is a disaster. Some are just minor setbacks in the journey. The same is true when an option trade shifts dramatically against you. Some adjustments can help put things back on track.
Today, Apple (NASDAQ:AAPL) is at $97.13 where it is currently testing support after dropping steeply with the rest of the market the past two weeks. Currently, the puts we wrote for 2/19/16 $115.00 @ $5.85 are $17.87 below market ($12.02 below our adjusted basis after deducting the $5.85 premium). With only 30 more days to run on the contracts, I am going to adjust my position to defer the immediate impact of this and narrow the current negative total return, all while getting more time for things to work themselves out or to readjust anew later with yet another roll-forward to improve even more (return to positive total returns).
Lets review our original thinking and current position by reproducing the AAPL section of Part 1 of the Dividend on Steroids series. After that, I will discuss how to adjust our current contracts and identify the prices available to do so at this time.
The following section about Apple is taken from part 1 of the Dividends on Steroids series to remind you of the position held, why, and the cost basis.
Apple ($21,830.00 of portfolio cash committed) is not generally considered an income equity, although more people are realizing it does have a strong, safe dividend and the staying power to insure it will be around for decades to come. The relatively high volatility in market price translates to generally very high option premium yields and can make the option boosted yield on the shares quite attractive. I chose AAPL for these reasons, along with its capital appreciation potential over the long term. My current YDP fair value estimate of AAPL for its $2.08 annual dividends at its historical 1.75% to 2.0% average yield rate is $104.00 to $118.86. Trading at a market price above fair value and in a technical pattern that is currently weak and uncertain, I have selected a cash covered put strategy with a strike price close to fair value to begin generating income from AAPL while I wait for it to come to my preferred buy-in price.
On November 18, 2015, I wrote (sold to open) two put contracts using the February 19, 2016, $115.00 strike and was paid a $5.85/share premium. Contracts are a standard 100 shares each (although AAPL happens to also trade with "mini-options" of 10 share blocks). My two contracts instantly paid me 200 shares X $5.85 = $1,170.00. If the shares do not decline below $115.00 or below by the contract expiration date on February 15, I will simply keep the premium I have already been paid and the contract will expire. My $5.85 premium income/share with net covering cash of $115.00 minus the $5.85 is $109.15. $5.85 income / $109.15 covering cash tied up for the 92 days of the contract is an absolute gain of 5.36% (21.26% annualized yield rate). As can be easily seen, this is far superior to the Apple 1.75% dividend annual yield and also a higher return rate than we can hope for from most stock investments generally.
On the other hand, if the shares are presented to me (due to falling to or below $115.00), I will have purchased them at the fair value price I wanted. The option premium looked at as an adjustment to basis price rather than income means I actually lowered my risk and have a breakeven for total return at $109.85 even if the shares move below the $115.00. My premium income of $5.85 per share is still cash income just like a dividend (which also figures as part of my total return). In this 92-day period, I have locked in a cash distribution of $5.85 per share while AAPL is only due to pay out one February 5th dividend distribution of $0.52 (less than 1/10th of my cash flow from the option boost). Furthermore, I got my payment on November 18th, not having to wait until the February 5th ex-dividend date and weeks more for the actual distribution.
If AAPL simply moves sideways for the next year with no net gain or loss and premium rates remain similar to the current yields, I can earn $5.85/share every 92 days (($5.85/92) x 365 days)) = $23.21 in premiums per year. $23.21 / $109.85 covering cash = 21.13% annual yield rate. This is the power of covered call writing. An over 21% yield rate if the shares remain flat. Few would expect to earn 21%/year on AAPL shares from share price capital appreciation, let alone from it staying flat. And that premium income generation is 11.2X compared to the $2.08 dividend income. Which way would you rather generate income from an income portfolio? Certainly, AAPL may go down in price over the coming year and I may not be able to write as attractive strike and premium combinations. But there are almost always alternatives at any given time on some quality ticker offering similar results. If I find myself owning Apple shares for $115.00, I will still earn the $2.08 annual dividend yield plus my $5.85 and at least some additional option premiums even if much smaller yield than this current situation. Even at only the $5.85 premium from this initial position plus $2.08 dividend over the coming year = $7.93. This is 3.8X the AAPL dividend alone and a 7.2% annual income yield on my basis as opposed to Apple's 1.77% dividend yield at current market.
Nothing has changed in the fundamental value of AAPL. The fair value remains at $104 to $119 per share. However, the price and momentum have developed strongly negative compared to the earlier environment. If presentation should occur today, I am comfortable owning the shares, harvesting dividends and selling long-term covered calls far out of the money (above my basis cost) to generate mild boosts in yield and income while awaiting an eventual improving of the market pricing.
An immediate presentation of shares would require I purchase them at $115. Even after allowing my $5.85 premium cash to adjust the basis cost to $109.15, I would find myself $12.02 in the red in terms of net total return to date. I prefer to soften the immediate blow and continue to build my boosted cash income while starting narrowing my net total return loss. I will do all this by rolling forward, buying the puts to cover for my 2/19/16 $115.00 @ $18.60. The $18.60 cost to cover yields a net deficit (loss) of 18.60 - 5.85 = $12.75. On the surface, this is a greater loss than the $12.02 deficit I am facing from an immediate presentation of shares under the existing contract. However, with the current contract released, I am at liberty to write new contracts (and earn new premiums to boost income and thereby adjust total net return results.
After buying to close for my existing February puts, I will then sell new at the current money put contracts for 1/20/17 $97.50 @ $13.05 premium. This will lower my strike price exposure to the current money (reduced $17.50) and return slight positive net return overall to the AAPL position, completely removing my exposure to the current $12.02 net loss.
The final result is that I end up with a net positive $0.30 premium boost from the original transaction plus this new one and have exposure to future presentation of shares at $97.50 instead of $115.00, with a full year to run on developments instead of just 30 days. This is a very good example of how rolling forward can help correct a minor derailment. We remain exposed to market risk, but we have completely eliminated the "legacy risk" that was in our original put contract. If need be, we can make further "roll-outs" as things develop in order to address market developments in the future.
I am not a licensed securities dealer nor advisor. My work presented here is specific and actionable but should be considered as analysis only and not taken as investment advice. As always, each investor should weigh the suitability of each analysis presented and do your own due diligence as you feel appropriate.
Disclosure: I am/we are long AAPL.
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.