By Gregory Dorsey
Leeb’s Income Performance Letter
Recently, I discussed using covered call options as a means for conservative investors to generate income and hedge their positions. Here we employ this strategy with several of our Growth and Income Portfolio picks.
We’re holding three gold related positions as disaster insurance: Barrick Gold (ABX), Goldcorp (GG) and the SPDR Gold Trust (GLD). They’ve been outstanding performers since we added them, and they will continue to protect your portfolio from a declining dollar, a deflationary accident or a wave of high inflation at some point in the future. But unfortunately, these positions pay little, if anything, in the way of income. Call options written (sold) against these stocks, however, is a way of creating an income stream.
Because of the somewhat arcane terminology involved, options can be a bit intimidating for the uninitiated, so we understand if you are a bit hesitant to take the plunge. But rest assured, the learning curve is not at all steep and the effort will be rewarding.
You’ll recall that a call option gives the holder the right (but not the obligation) to buy a stock at a predetermined price within a specific period. In return for holding out your shares for possible sale at that set price, as the option “writer” you’ll collect a premium from the option buyer up front.
If done correctly, selling call options against stock you own can generate additional returns of up to 10% annually, on top of the potential for capital appreciation (albeit capped) on a given stock. The trick is to not reach for too much income when writing the options.
All things being equal, the closer the underlying stock is trading to the option’s “strike” or exercise price (and likewise the more it’s above the strike), the more call option will cost (and the more the option sell will collect). The tradeoff is that the closer the shares are to the option’s strike price, the greater the likelihood your option will be exercised (the stock called away from you).
You therefore want to find a happy balance that produces good income while allowing you to enjoy a decent amount of appreciation before possibly having to surrender the stock. As a rule of thumb, we prefer writing options 10 to 15% above the current share price and that expires in less than three months.
With Barrick Gold trading around $50 at the time of this writing, for instance, you can write a Barrick October 55 call and collect approximately $1.50 per share. Each contract represents 100 shares, you’ll collect $150 (100 x $1.50) per contract sold. So long as the stock remains below that $55 strike by the option’s expiration on the third Friday in October, you’ll keep your shares, plus the $150 premium, and you can then write another option to repeat the process.
In fact, you’ll keep that $150, regardless of what happens to the stock. Should the stock decline from the current price, the money you receive for writing the option will reduce your cost basis in the shares, easing the blow. And you can enjoy roughly $5 per share in appreciation in the stock before it can be called away from you, which along with the $1.50 you received for writing the option will give you a total return of more than 13%. Not bad for a couple of months work on a position you are holding anyway! And since gold stocks will travel together, you can always buy back the stock or another just like it.
Let’s look at another possibility with the SPDR Gold Shares (GLD). At the time of this writing, the ETF is trading around $171 a share, while writing an October 190 call option will fetch $2.80 per share. By selling that option, you’ll increase your return on the position by about 1.5% in exchange for being willing to sell your shares if they rise 11% from their current level. While there’s always the chance that GLD will continue to rise beyond that level, given the move gold has made of late the risk of that happening is reduced. And again, you can always immediately buy the ETF back again if need be.
The first thing you’ll need to do to get started is have your account cleared for options trading. Covered calls (Level 1 trading privileges) are the most conservative options strategy and can even be employed in individual retirement accounts.
Select a strike price that is approximately 10 to 15% above the stock’s current price. When placing the order with your broker to write the covered call, you’ll “sell to open” the position. If you later need to exit the trade, you’ll use a “buy to close” order.
An option’s price is a function of several factors, including the premium to the current share price, the time until expiration, the expected volatility of the underlying stock, and the stock’s dividend yield. To keep things simple when placing the trade, you should use a limit order near the option’s current bid price.
Options writing isn’t for everyone, of course: It requires more effort than merely taking a buy-and-hold approach to investing. But it can make the difference between a good return and a great return on your investment.
For more information on covered call writing and options in general, the Chicago Board Options Exchange (www.CBOE.com) is an excellent resource. The site includes an application for virtual trading, so if you want, you can practice what you’re doing without committing actual funds.
What to do now: Use covered call options to supplement returns on your low-yielding stocks.
Editor’s Note: Gregory Dorsey is portfolio editor of Leeb’s Income Performance Letter, P.O. Box 248, Williamsport, PA 17703, 1 year, 12 issues, $199. www.leebincomeletter.com.
