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MAKING CENTS OUT OF THE NEWS
Blog #19
(May 14th, 2009)
STOCK OPTIONS - IT'S ALL IN THE WAY YOU USE THEM
By Tom McAllister, CFP™
Think stock options are a speculator's game, too risky-too hot to handle? Think again. Option strategies exist that can actually take risk away from you and transfer it to speculators!
The very simplest risk-avoidance option strategy is called a "covered call". The owner of the stock sells a "call" on that stock to a speculator, in exchange for a fee called a "premium". The owner thus gains income (from the premiums paid) which transfers some risk. The speculator, who is willing to take risk, has the most to gain if the price of the stock rises sharply. A riskier version of this same strategy involves selling calls without owning the stock. That is called "naked selling," and is in fact speculative.
There are literally hundreds of stocks that are available for option trading, generally on the Chicago Board Options Exchange or on the American Stock Exchange. Most investment portfolios contain at least several such stocks.
For purposes of illustration, I will use two actual trades done by one of our portfolio managers. (Commission costs are ignored to simplify the illustration.)
Example #1 General Electric (Background: Our manager purchased GE stock for the long term, despite the fact that we are not fond of the company's management team.)
Our manager had purchased the stock for $8.93 per share. Three weeks later, the price had gone up to $10.28 per share. The manager (seller of the covered call) collected a call premium from the buyer of 50 cents per share, giving the buyer the right to purchase the GE stock at a price of $13 per share at any time up to the expiration date in June.
Seller's benefit:
a) Seller still owns the stock plus the 50 cent premium. Keep in mind that the premium itself amounted to 4.86% of the value of the stock at the time. That is a 19% annualized yield to the seller!
b) If the buyer exercises his option, seller will collect no less than $13 per share.
c) Seller maintains the right to repurchase the call on the exchange just prior to expiration and continue holding the GE stock long term.
Seller's "risk":
If the buyer "calls" the stock, seller gets $13 per share. If GE later goes up to $20 per share, the seller has "lost" the opportunity for that appreciation above the $13.
Buyer's benefit:
The call buyer believes GE will go up well beyond the $13 price. The 50 cent premium guarantees him the right to purchase at $13 per share even if the price at that time (obviously before June, when the right expires) is $20 or more.
Example #2 Shaw Group
The Shaw Group, Inc. offers engineering, technology, construction, fabrication, environmental, and industrial services, including nuclear power installations, to various companies worldwide. It was purchased as a mid-cap value stock with the intent to hold it for several years.
A parallel option transaction was done with the Shaw Group. The call was sold for a premium equal to 8.91% of the market value of $29.17 a share, an annualized 26% yield. The seller had already made money on the stock, which had been purchased for $18 per share and, at the time of the selling of the covered call, was worth $29.17 per share. As the expiration date approaches in July, the manager can either let it be "called" (at $35 a share), or buy back the call a day or two before it expires.
In retrospect, both these covered call transactions turned out to have been excellent moves. Both stocks have rallied strongly from their purchase price, and both premiums were at attractive prices to the seller, thus “cushioning” the owner from any possible pullbacks in the market. Both transactions are excellent examples of using stock options to lower risk.
We have had an approximate 35% upward move in the stock market since March 9, just two months ago. A pullback of 8-12% from these levels would not be unusual; in fact, it can be expected. Using a call selling strategy such as the ones outlined above is a way to "capture" gains investors have enjoyed in just two months' time.
I was manager of Robert W. Baird’s Indiana office on May 1, 1973, when the Chicago Board Options Exchange began trading. We utilized covered call strategies with great success in our office during the next two terrible years in the stock market, thus pioneering Baird’s option operations.
I suggest you call us at 1-800-663-3419 for additional information on covered call writing and to discuss whether it can be an appropriate part of your own investment strategy.
With all the rapid changes in our economy and in the investment markets, there are many investors who would benefit from more consistent guidance. We are currently accepting new financial planning and investment clients, and would appreciate your referrals.
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