Pendola Investor Options Newsletter - First Issue
Long-term investors often eschew options because they associate them with increased and unnecessary risk. In my options eBook, I illustrate how to use entry level options strategies, such as covered calls and long calls and puts. While this newsletter focuses on covered calls, future issues and updates help you employ puts to follow bearish convictions as well as calls and puts to make long plays, hedge portfolio risk and generate income. The primary goals center on growth, mitigating risk and maximizing income generation in as many of your positions as possible. We will also include riskier trades, from time to time, to satisfy the speculative compartment that many investors keep in their portfolios.
In this week's inaugural newsletter, I set the table for the model portfolios and trade ideas that will guide the proceedings by explaining why covered calls hold so much value for long-term investors, particularly ones after income.
Note: When we refer to options in any of our newsletters or updates, we speak of American-style options (We do not discuss European-style options, which play by different rules, thus are priced differently).
The Covered Call
In options, it does not get much more straightforward than the covered call. A covered call requires you to sell (write) a call option while you own or at the same time as purchasing (known as a buy-write strategy) 100 shares of the underlying stock. If you sell two calls, you'll need to own or buy 200 shares of the underlying stock to keep both contracts "covered" and so on.
Because a call option gives its buyer the right to buy 100 shares of the underlying stock at the strike price on or before options expiration day, you must be prepared to deliver (sell) the stock at the strike price, regardless of its market price at the time of assignment. (When you sell/write a covered call, you are selling it to another party, thus obligating yourself to the terms of the option contract). For example, if you sell a Ford ( F) February $14 call "covered" by 100 shares of F, you'll need to hand those shares over to the call buyer, at $14 a piece, no matter what ( F) trades for upon assignment. Of course, you'll likely only get your shares called away if ( F) trades up and over the strike price on, and in some cases, before options expiration day.
If you have a $10.00 cost basis on your 100-share lot of F, the most you can make on the trade, excluding commission charges, is $400. Because you must sell the stock for $14 per share, you leave any profit above that level on the table. For instance, if ( F) traded to $15 and the call buyer exercised the option, you would sell him/her 100 shares of ( F) at $14 a piece, turning a $400 profit on the stock trade, but leaving $100 on the table. (Of course, you keep the premium received from writing the call no matter what happens. You will not have to give up your shares if the call buyer does not exercise the option. In most cases, it will not get exercised unless it moves into in-the-money territory on or before options expiration day. If the option closes $0.01 or more in the money at expiration, it gets automatically exercised, unless the call holder instructs his brokerage to do otherwise).
That's a major "risk," if we can call it that, of writing covered calls. You lock yourself into selling your stock at a particular price. Of course, you could always "buy to close" the option position, but if you're doing it to save yourself from assignment and losing your shares, there's a good chance, you'll be buying it back for more than you paid for it, resulting in a net loss on the trade. The possibility also exists that you will not close out the position in time. The call buyer will have already exercised the option, rendering your buy to close order void.
The "risk" of losing your shares should rarely, if ever, come into play. When you select a strike price for the call you would like to sell, ask yourself how you would feel having to give up your shares at hat price. Be sure to factor in the premium you received for selling the call. That's income. And that's one of the main reasons why you execute a covered call - to maximize the income generation potential of individual holdings in your portfolio. My Ford example is not the best because you would have only collected roughly $0.08 ($8.00) in premium income, as of this writing. Nevertheless, you can factor this into the strike price, bringing the effective price you would be selling your ( F) shares for to $14.08.
This example of a call you would likely not right if you own a small lots of shares not only clearly explains covered call writing, it leads nicely into a very important topic.
Choosing A Broker
Enter the issue of commission charges, particularly if you're trading a small number of contracts against a relatively small number of equivalent shares. At most mainstream brokerages, you would pay just as much in commission to sell that Ford call. It makes no sense to even put the trade on.
Two thoughts. One, you're probably better off using a different strike or month to maximize the income on a small number of contracts/shares. Two, in the case of the small investor as well as one who "trades size," you'll want to find a broker with better rates on options trading. At Schwab, you'll ay $8.95 for the trade, plus $0.75 per contract online. That amounts to more than the ( F) February $14 call generates in income.
Of course, you could call Schwab and ask for a better rate. They'll likely give you one, but it will not be more than a dollar or two discount unless you have a considerable amount of money with them (minimum of mid- to high-six figures). Give it a shot, as anything is possible, but that's likely the way it will go down. Brokers such as Interactive Brokers charge much less to trade options. Here's a screen capture from the IB Website that shows the difference.
For the record, IB does not pay me to promote them like this. I actually like Schwab quite a bit – just as much as I like IB - but for different reasons. There's absolutely nothing in it for me when I make mention of either company. I do, however, feel like I am providing subscribers value by pointing this out, particularly if you never knew that a brokerage with the options commissions IB offers exists. Heck, if you were to make such a switch, the savings in trade commissions pays the price of this subscription, possibly, for months on end.
A quick "bearish" note on IB - Do not expect excellent customer service. While it all depends on who answers the phone (and