Setting Up A US Income Portfolio With Call Options

Peter Hodson This is my first article for CMS in four years. Since buying CMS and starting 5i Research, I have been pretty busy. We’ve hired a few smart people, though, and things are getting easier now. Since I get a lot of questions from customers about how I invest my money, I thought I would highlight a strategy that has been successful for me. Because of 5i’s no-conflict rules, I can only invest in non-Canadian securities, so I thought I would outline a strategy to earn US income using covered call option strategies.

I won’t go into details on options, and it is a sector of the market that you need to be familiar with if you want to even attempt this strategy. Basically, a call option gives the buyer the right, but not the obligation, to buy a security at a certain price, for a defined period of time. For this strategy, you are the option seller. You get to keep the premium paid by the buyer regardless of what else happens.

For a quick example, suppose you own 100 shares of Apple, bought at $109.50 per share, for a cost of $10,950 (all figures in US dollars). A November $110 call option trades, at the time of writing, for $4.90 per contract, and each contract represents 100 shares. You could write (or sell) one contract, and get $490 in premium.

With a cost of $109.50 per share, your net cost is now $104.60, after accounting for the $4.90 premium received. Now, all you do is wait until November 20, 2015, the expiry date of the option. If Apple is trading below $110, nothing happens. You keep your stock, and can do what you wish with it. If Apple is at or above $110, though, you have to sell your stock at $110.

If your option is exercised, you sell at $110 per share. But your net cost was $104.60 per share. Thus, your return is $5.40 ($0.50 profit per share, plus $4.90 in option premium). That represents a 5.1% return, in (from the time of writing) a 43-day period. Annualizing that return, of course, makes it a very impressive 43.8% rate of return if the option is exercised. If Apple falls, you still get to keep the $4.90 per share in premium income, for a 4.6% return on your net cost.

Thus, regular, consistent option selling can significantly boost your income on a portfolio of diversified stocks. It is not a strategy for everyone, but can work in sideways and volatile markets. The strategy will limit your upside gains in a bull market, but if your focus is income, then you will be alright with this. Keep in mind that the option premiums provide some, but not much, protection in a market decline. Your stocks will still go down in a bad market, but you will have a little bit of offsetting income that you otherwise would not have received.

The Keys To This Strategy:

Use stocks you would be comfortable owning anyway: This is perhaps the key thing to remember. Many option writers see high premiums on certain volatile stocks (usually in the technology or biotech sectors) and then buy stocks and sell options on companies they are not familiar with. Then, they find the volatility of the stocks a little too much to take. Remember, call writing is an income-generating strategy, not a strategy to add even more stress to your investment life. Stick with companies that you would be happy to own anyway. Remember the basics, and do not ‘reach’ for returns by buying smaller, more speculative positions.

Sell options primarily on stocks that pay a dividend. Since call writing is designed to boost your income, selling options on companies that pay dividends can potentially boost it even more. If you are selling options on a regular basis, then every three months those positions that have not been called away will pay you a dividend. It is a nice little bonus in an income-enhancing plan. Apple Inc. for example, might be an ideal candidate for an option strategy. It yields 1.9%, if your stock does not get called away. Because it is a volatile stock (but large, and safe, with $200 billion in cash), you can earn about 3% more per month from at-the-money call option premiums. Suddenly, a relatively secure blue chip stock turns into an income machine.

Preferably use companies who have a high amount of cash and little debt: Another key to an options strategy is to limit your downside risk. What better way to do this than to use companies that have no debt and lots of excess cash? Cisco (CSCO on NASDAQ) for example, has $35 billion in net excess cash, representing about one-quarter of its market value. Still, slightly above the money call options can return about 4.3% in 45 days, if exercised. The cash should provide a cushion in a down market, allowing you to continue to sell calls if your position is not called away.

Use companies whose stocks are more volatile than the market: Options premiums depend on volatility. The more volatile the stock, the higher the premiums on options. As mentioned, many small and mid cap stocks are very volatile, and we do not suggest using a call-writing-income strategy on these. But you can still find large companies with stocks that are exceptionally volatile. Netflix (NFLX on NASDAQ) might be a good example. Its market cap is $45 billion, but its stock swings around like a yo-yo. At the time of writing this, a nine-day in-the-money call option nets you an 8% return. Now, the company could miss estimates and fall sharply, but you have at least an 8% cushion on any drop, and you can always sell more options if that occurs.

Use short-term options only: We think this is the most important point other than the first point of owning companies you are comfortable with. As indicated, with many stocks you can get option premiums of 3%, 4% or more in a very short period. Some stocks will swing wildly, of course, but on average stocks do not move that much in a month. We have found that using this strategy with one-month options works best. If you set up a diversified portfolio, you will find that most of the time you will just collect premiums, which will enhance your income. In a rising market you will get called away more often, of course, but hey, it’s a rising market and you are still going to be doing fine with your portfolio.

Do It Consistently; do not play it cute. Sometimes, when a stock falls, you may be tempted to ‘wait for a recovery’ before selling more call options on the position. Do not do this. This is an income strategy, not a ‘hope’ strategy. When an option expires, sell new call options right away, collect the extra income, and see what happens. As mentioned, it is rare for stocks to move dramatically in a month, and a stock that has fallen has an even tougher time recovering in the short term. Get more income in, to reduce your cost on the losing position.

Use Enough Stocks To Be Diversified: If you use covered call options on nine to ten stocks, you will be able to cover most sectors. Some will get called away, some will not. Like any investment strategy, diversification will protect you.

Be careful not to end up with ‘Losers’: One of the big problems of the covered call-option strategy is that ‘good’ stocks will get called away and you will be forced to sell them. ‘Bad’ stocks will not, and you will be able to sell more options on them. However, you need to be cautious not to end up with a portfolio of losing companies whose shares never rise. For the best returns, you WANT your options to be exercised at higher prices. If you end up owning a consistently underperforming stock, just like with a non-option portfolio, considering selling it and replacing it with something else.

We have selected the next-month option, at the closest price above the current stock price. Prices as of October 8, 2015, thus, for example we used Apple Inc. November $110 calls in the table. (Facebook Nov. $92.50, Cisco Nov. $28, Garmin Nov. $37.50, and Cal-Maine Nov. $27). Commissions and taxes excluded.
Note, annualized returns assume each month (43 days in the example) options are exercised. This is unlikely to occur on a consistent basis.

Table One provides an example only of some of the returns possible. As Peter Hodson mentioned, we think you should use 9 or 10 stocks, but the table includes just five for information purposes. Also, because of the time delay on printing CMS, we are using average one-month call option premiums, rather than specific options quotes. We think you will find current premiums very similar, however, unless there are wild market gyrations between the time we write this and the time you are reading it. Note we have not considered commissions and taxes in this column, both of which will reduce your net returns.

As you can see, returns can be quite impressive even on short-term call options. As noted, the key thing here is the volatility of the underlying stocks. They do swing around. But all five companies in our example also have a very large net cash position. For example, Garmin, while it has been weak this year, has $2.5 billion in cash against a market capitalization of $7 billion.

This strategy has worked very well for me. Keep in mind, though, that I have more than 30 years of investment experience (I guess I am getting old).

If you would like to do more research on the strategy, we would suggest starting here:

http://www.investopedia.com/university/options/

Peter Hodson, CFA, Head of Research at 5i Research Inc, an independent stock research company, research@5iresearch.ca, www.5iresearch.ca and Editor-in-Chief of Canadian MoneySaver.