When People Are Happy, Protect Your Portfolio
November 12, 2007 | Joe Ponzio | about: AEO / JNJ
Last week was a wild one for stock prices. The Dow lost 4.1% (threatening 13,000); the S&P 500 was down 3.7%; the NASDAQ lost 6.5%. It was crazy enough to make most investors quake in their boots.
I don’t try to predict the direction of the markets on a daily basis; still, I hate to lose money. That’s precisely why I like to sell options from time to time.
An Options Primer
Options can be risky investments – particularly if you are buying them or selling them “naked” (when you don’t own the stock). An option is a contract – a right to buy 100 shares of a company’s stock at a particular price. If you are entirely new to options, The Chicago Board Options Exchange (CBOE) has some great tutorials and basics on options.
Selling Covered Calls
When you sell “covered” calls, you are selling a contract to deliver 100 shares of your owned stock at a specified price if the stock price gets above the “strike” price by a certain date. If the price doesn’t get above the strike price in that timeframe, you keep the stock and the premium that someone paid you for that option. If the price does get above that price, you deliver the shares you own…but you still keep the premium.
Reducing Your Basis
Selling options does not actually reduce your cost basis in a stock as far as the IRS is concerned. Still, cash is king no matter what the tax laws say. If you bought 100 shares of Johnson & Johnson at $65.86, you would spend about $6,596 (assuming a $10 commission). If you then sold one contract of the December $65 call, you would collect about $1.90 per share – or $175 (assuming a $15 transaction fee).
You would have essentially invested a net amount of $6,421 ($6,596-$175) to own 100 shares of JNJ. Here’s the rub: someone bought that contract you sold. In order for them to be profitable on that call, JNJ has to get above $66.90 ($65.00 + $1.90 in premiums) by the third week in December.
If JNJ gets above $66.90, you deliver your 100 shares, and you net roughly 1.2% in gains in one month. If JNJ doesn’t hit that price, you keep your 100 shares and the $175 premium.
A Bad Example
Now, JNJ is actually a bad example because the option premiums aren’t all that high – certainly not high enough to warrant risking your potential gains on such a solid, stable company. If, however, you own stock in a company with extremely volatile stock prices, the premiums are generally higher.
AEO, stock and options
Like most retailers, American Eagle Outfitters has seen its stock hammered over the past few months. Still, everyone at AEO is going to work every day to make money for us silent partners. Today, AEO is trading around $22.20. I don’t know what the price is going to do over the next few weeks or months. Still, I know I have people in at $23.02 per share.
Immediately after buying AEO at $23.02 a share, we sold the December 25 call against it and netted $0.88 a share. In essence, we have $22.14 a share in AEO – $23.02 on the stock minus $0.88 on the option.
Best case scenario: AEO does not hit $25.88 by the third week in December; everyone still owns AEO stock; everyone keeps the premium.
Worst case scenario: AEO hits $25.88 by the third week in December; we deliver AEO stock that we bought at a net price of $22.14; we earn a 13% return in six weeks (164% annualized).
The risk: AEO goes well above $25.88 and we miss substantial gains because we were shortsighted.
What to look for when selling calls
Don’t just run out and buy stocks for the sake of buying stock; don’t sell calls for the sake of selling calls. Be selective.
When looking for calls to sell against my portfolio, I look for three things:
- The markets have to appear to be near their peak for the month. I don’t expect to go from 14,000 to 15,000 in one month this year; still, to go from 13,000 to 14,000 wouldn’t be all that surprising. I sell calls when everyone else is happy to buy them.
- The premium must have a meaningful impact on my basis. I don’t sell calls that yield so little (e.g., JNJ above) that delivering the shares would give me a mediocre (or bad) return.
- The strike price must be above my net cost basis. I don’t want to deliver shares for a loss when I hold a phenomenal, underpriced business for the long term.
Note: In number 3, I say my “net cost basis”. Let’s see what would happen if AEO didn’t hit $25 until July of 2008.
When price won’t budge, your cost basis still can
If the market stayed stubborn, pricing AEO at $20 to $24 for the next eight months, and I kept selling the $25 options against it (assuming the premium was a consistent $0.88), my “net AEO basis” would look like this:
| AEO Calls | Last AEO Basis | Option Premium Received |
New AEO Basis | Stock Price | Net AEO Gain |
| Original Purchase | $ - | $ - | $ 23.02 | $ 23.02 | 0 % |
| December $25 Call | $ 23.02 | $ 0.88 | $ 22.14 | $ 23.02 | 3.9 % |
| February $25 Call | $ 22.14 | $ 0.88 | $ 21.26 | $ 23.02 | 8.2 % |
| April $25 Call | $ 21.26 | $ 0.88 | $ 20.38 | $ 23.02 | 12.9 % |
| June $25 Call | $ 20.38 | $ 0.88 | $ 19.50 | $ 23.02 | 17.9 % |
| August $25 Call | $ 19.50 | $ 0.88 | $ 18.62 | $ 25.88 | 34.3 % |
If, come July of 2008, AEO then rose to $30 a share while I held the August option, I would deliver my stock at $25. With a net basis on AEO of $18.62, I would have a 34% return (slightly higher when annualized) be selling the options as compared to a 30% return had I not sold any options.
You have options with options
Of course, the above begs the question: What if AEO ran up to $40 but you delivered the stock at $25?
When you deliver your stock, you have two choices: Buy it again if it is a wonderful company or move on to the next investment opportunity. So many years from now, when you look back on your investing career, you will not judge your success by how much you made or missed on a particular stock – you will judge your success by how comfortably you have set yourself up for life.
Have I missed some high flyers? You bet. But I’ve also turned some dogs into winners (or break-even) because my judgment of value was wrong but my options plays were right.
Watch your fingers
Some parting advice on options: Don’t sell “naked” calls (selling when you don’t own the stock). Don’t sell puts. Don’t buy stocks just because the calls are priced juicily. Have patience when you buy your stocks; use options wisely; make investing a business.
Am I saying you should dabble in options? No. But they’re worth a look.
Filed under: Workouts, Arbitrage, & Hedges
MikeR,
I like that strategy and have used it in the past as a way to collect money while waiting for the market to trade to my buy level. When the market becomes more volatile I stop using this method because it is more likely that the market can trade below your strike and then higher. In your specific case of AEO the market traded as low as 21.08 on 11/08/2007. If by Friday the stock is trading above your strike (22.5) then you will have gained the premium of the options, but lost having the true position you wanted. What if the stock is trading at $23 at Fridays close. Are you willing to now buy the stock at that level? Will you wait until the stock get back down to 22.5 or below to buy it? Or will you sell more puts?
The problem with the strategy is that you are not in control. You are depending on the market and someone else to put you into the position that you want.
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Joe,
Under REDUCING YOUR BASIS, you say “If JNJ gets above $66.90, you deliver your 100 shares”; I think that should read, If JNJ gets above $65.00. The buyer doesn’t make a profit until the price goes above $66.90, but you forfeit your shares at the strike price of $65.00 or higher.
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MikeR,
I like that strategy and have used it in the past as a way to collect money while waiting for the market to trade to my buy level. When the market becomes more volatile I stop using this method because it is more likely that the market can trade below your strike and then higher. In your specific case of AEO the market traded as low as 21.08 on 11/08/2007. If by Friday the stock is trading above your strike (22.5) then you will have gained the premium of the options, but lost having the true position you wanted. What if the stock is trading at $23 at Fridays close. Are you willing to now buy the stock at that level? Will you wait until the stock get back down to 22.5 or below to buy it? Or will you sell more puts?
The problem with the strategy is that you are not in control. You are depending on the market and someone else to put you into the position that you want.
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Selling covered calls is a strategy you should be employing for those stocks you own which you might not regret getting called away. If you believe that a particular stock can give a better annualized return in whatever time frame you have, dont even think about writing covered call, because you will miss big gains if the stock is called away. This is especially true if you are a value investor and waiting on a stock to be realized by the street, any event which transpires can push the price up and you have absolutely no control on it.
I write covered calls only on those stocks whoese IV , i cannot estimate properly, but are good stocks. Recently, I wrote CC on NSTR. Its a medical device company trying to get PMA for its Investigational device for stroke recovery. One reason, the premuim was high. Second reason, Its tough for me to value the stock, there are no earnings , no assets, only promises.
I differ on the idea “Don’t sell puts”. If you are a good stock picker, writing puts is the best strategy to buy the stock at a lower cost base. Writing puts is no way more dangerous than buying the stock outright. You CANNOT prove otherwise.;try it.
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Dave Miller,
That is the downside, that I give up gains because the stock takes off and I don’t own it because I won’t get put to. Still, it is a conservative strategy and keeps me from jumping in too soon because I get that “don’t want to miss out feeling.”
What I also do is once I have my position, if the stock hasn’t moved, I’ll write puts again. If I get put to I write covered calls. I repeat till the stock moves away from my entry position and I am left with the number of shares I want to have and all the put and call premiums. Of course I have to be comfortable with having a larger position for a time than I originally planned.
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Well, I have two pieces of good news. The first is that my son just learned and successfully played the long opening rifts to Sweet Home Alabama on the guitar. Nostalgia is the crippler of young adults, and, given my more advanced age, it evidently defies cure into middle age, as well.
The second piece of good news is that I am looking for a brilliant member of the board to check my math on another round of market and AEO analysis.
A couple of nights back, I downloaded the data for the S&P 500, intent on duplicating / accepting or rejecting Ken Fisherâ??s comparative analysis of stock yields and bond yields from a couple of years ago. If stock yields (earnings divided by price) are more than a percentage point or two greater than bonds, then prime-grade corporate bonds (which follow government bonds at a small premium) represent a cheap form of financing corporate growth and expansion. Historically, this spread has predicted economic and market booms in the US and other first world countries, as well.
So, here is what I did, along with the math:
The weighted average forward PE for the S&P 500 as of Tuesday’s close was 14.02. This puts the equity yield at 7.13 percent (100 / 14.04 = 7.13). The 10-year bond yield came in at 4.07 percent (an un-adjusted PE equivalent of (100 / 4.07 = 24.57). Adjust for a conservative 25-percent tax rate (corporate rates normally approach 40 percent), and the bond’s comparative value is roughly 3 percent [4.07 x (1 - .25) = 3.05].
In other words, returns from the stock market exceed the risk free cost of capital by 4 percent (3 percent if not adjusted for tax differences). To achieve parity, the average market PE would need to rise from 14.02 to 24.57 — through, either, an increase in price or a decrease in earnings to close this spread [100 / 4.07 = 24.57].
So, let’s assume the worst case scenario — prices stay at current levels and earnings decline under a weakening market. Check my math, but I believe earnings would need to drop by between 42.7 percent and 57 percent [7.13 x X = 4.07, 4.07 / 7.13 = 57.06 percent on the high end and 7.13 x X = 3.05, 3.05 / 7.13 = 42.8 percent on the low end]. While stock market corrections, by definition, require a decline of 10 percent and bear markets require a 20 percent decline, I don’t believe the market will drop by more than 42 percent or, worse, more than 50 percent. Why? The Yen carry trade works in both directions â?? i.e., US corporations can finance debt in Yen â?¦ [raising the question of why the US government isnâ??t doing the same thing (China is buying US bonds), but that is another matter]. I also don’t believe it because the ‘87 crash dropped the market by roughly 23 percent … in one depressing and alarming day.
Regardless of the market, AEO is currently selling at more than a 60 percent discount if expecting its 10-year growth rate to drop by more than a third. In other words, such a market crash seems priced in the stock value at this level. Even if projecting that AEO will post 0.00 percent growth over the next decade and just 5 percent from years 11-to-20, AEOâ??s intrinsic value is $21.49 (by DCF model, applying a 15 percent discount rate) â?? 3 cents lower than yesterdayâ??s closing price.
Now, the short argument is that the dollar is going to hell, the market is falling, government debt is high, a recession is coming, and inflation is growing. The worst short prediction Iâ??ve seen is for a deep recession â?? not a market crash and depression. None are arguing that the market is a speculative bubble with a forward PE of 14. So, the question naturally becomes one of why is AEO so overvalued that it has a lot further to fall, what is it about the economy that isnâ??t already priced into the stock, and / or are there any false assumptions or miscalculations in my model?
Full disclosure, following Joe’s posting, I performed this analysis and posted it on the Yahoo discussion board — where a rabid group of shorts once congregated. None was able to attack this, which proves just one thing. Namely, most shorts, like longs, are playing momentum rather than fundamentals. But that should be saved for a different discussion.
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So, I’ve done my first experiment with selling covered calls.
I sold 3 covered calls for March strike 25, for $1.20/share. My cost basis in AEO is now $20.80/share. I made this transaction for two reasons..
1. If I am forced to sell AEO at 25 (so if it reaches 26.2), I have made a ~20% gain since I’ve held it. Which satisfies me. I will then have to cash to engage in a workout or two I have my eyes on.
2. I can make some change buying back the options if there is some random thing that makes everyone sell off their AEO.
Is my reasoning sound? Anyone have an opinion?
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Dear <del>Abby</del> Joe,
Having just written my first calls, I’m very interested in how to decide when a premium merits writing a call. Most of the stocks I’ve been looking at have a small premium for, say, a month out. I’ll throw a few numbers up:
My initial purchase: $10K
Price: ~$33/share
Shares: 300
So I could write 3 calls for $35, a month out. Say that the premium is .5, so I would make $150 – commission: ~1.3%*. The other choices are to buy farther out, and reduce commissions (since I only have to buy once – but usually the premium seems a bit lower) or to buy higher and also reduce commissions, often to pretty low (e.g., $40 a month out means a .15 premium, netting me a pretty measly $45 – commission = ~.3%*)
*(monthly)
How do you make the decision? If I’m buying the stock, obviously I think it will go up at some point, so how do I decide what cushion to leave the price before my stock might get called? In this case $35 leaves me a 6% upside 1.3%premium. $40 leaves me more upside, but way less premium… Seems like gambling.
Another possibility – wait a bit and see if the price increases and then write a call on that higher price, increasing my premium a bit.
Sincerely,
Call me Confused
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Miguel — I don’t have a hard, fast rule for determining the options. I don’t go far out; rather, I focus on the short-term options — one or two months mostly. I will sell calls against positions when I am getting an attractive return (more than 1% for sure, but no definite rule) and the markets have to be relatively high.
In this case, the markets were high in my opinion. I did it again over the past few months when the Dow would hit around 13,000. I don’t try to predict the markets per se, but I do know when I think they are overpriced in the real short term. I saw no reason for the Dow at 13,000 last week, so I would have felt comfortable selling a call. If the Dow were to hit 12,000 this week, I wouldn’t be selling calls.
Though I don’t try to predict the markets, I will use them to help me decide whether or not people are happy and if I should consider selling calls. If you see an option opportunity jump out at you, take it. If not, relax a bit.
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Be careful, be very very careful in this kind of market to write a covered call. Make sure that you can afford the downside of 20-30-50%! versus the 2-3-5% gain through CC.
There is a nice article I read at: http://www.radioactivetra...
This guy lost his shirt on the CC strategy.
The bottom line is, first protect your investment, then write the CC.
A better way is to buy a PUT immediately with the purchase of the stock, and then write CC on 50-70% (depending on the outlook and risk level) of the holing to reduce the cost of the PUT. This will keep the downside protected, and still have the upside potential.
Note: I am just an individual investor/trader and no interest with any of the website mentioned, just trying to bring a perspective.
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AB: The only way that Kurt (in the link you provided) could have lost everything writing covered calls is if he was holding naked calls too (more options than he had in his stock position). If you buy 100 shares of stock at $18, you put up $1,800. Then, you sell a one-month call at $20.00, and collect $0.60 x 100 shares, or $60. Your net investment is now $1,740.
If the stock goes up beyond $20.60, the option can get called and you deliver your shares at $20, pocketing $2,000. You just made $260, or 15%. The stock could do anything, but you can’t possibly lose your shirt selling this covered call. In fact, if the stock goes to zero, you’ll cash out better than most by keeping the $60 premium (while everyone else loses 100% of their money).
Kurt’s strategy tells you to buy puts. In that case, you would buy the one-month put at $15.00 and shell out another $0.30 x 100, or $30.00. Now, your investment is $1,830. If the stock continues to drop, the markets are offering you a chance to buy a great business at a lower price, but you’re already in a contract to sell that business at $15. If the stock never hits that $15 mark, you’ve wasted $30. If it does hit that price and your shares are taken, you have to buy the wonderful business again.
Kurt seems to be an options trader, looking to profit from every move in the markets. I’m not. Instead, I am simply trying to capitalize on peoples’ fear and greed. Buying at $18 and watching the price drop to $14 is not scary to me — it’s an opportunity; I see no need to %u201Cprotect%u201D a portfolio against opportunities.
Make sense?
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Joe,
I have been doing something similar to acquire my positions. For instance I wrote some 22.5-strike November puts on AEO. (Actually wrilting a put is equivalent to selling a covered call.) I may not get put to at 22.5 on AEO, it could be close. But if I do I pocket the put premium and have my AEO at the price I wanted, otherwise I just pocket the put premium. This has actually helped me to be patient to get into positions at a desired price. For instance, if a stock is sellilng at $26 and I think my entry should be $25 I write the $25-strike puts to force myself to be patient and wait for my price. If it doesn’t happen I still get the premium and that seems to satisfy me and keep me from entering too soon.
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