When People Are Happy, Protect Your Portfolio

By Joe Ponzio on November 12, 2007  |  15 comments

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:

1. 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.
2. 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.
3. 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:

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.

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