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(Michael McCloskey/iStockphoto)
(Michael McCloskey/iStockphoto)

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Expand your income with covered calls Add to ...

Many people have the impression that option investments are only for short-term speculators, looking to make a quick buck on a “flyer.” I hope that I have disabused regular readers of this column of that notion, but just to make the point perfectly clear and also to illustrate the flexibility of options as an investment choice, I wanted to spend this month’s column talking about a recent transaction I recommended.

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This investment extended the life of a previous shorter-duration option investment and allowed us to create a custom-made dividend stream of our own. This investment involves the popular “covered call” strategy.

Anatomy of an option investment, part I Like StockInvestor Editor Paul Justice, I have been impressed by Cisco Systems’ ability to generate cash and healthy returns due to its position of industry leadership. Also like Paul, I was willing to overlook a few disappointing quarters while management made organizational changes to shift focus away from consumer applications like Flip video back to its core networking business.

However, most of the market is not as patient as Paul or me, nor are they as sanguine about quarterly earnings reports. In February of this year, Cisco reported earnings and its stock fell heavily soon thereafter.



I knew that as an option investor, this was a good chance for me and my readers. I recommended entering into an investment called a cash-secured put (whose risk and return profile is identical to a covered call, as I will discuss later in this article).



Selling a cash-secured put simply means that we are promising to buy a stock at a certain price (called the strike price) at some point in the future at the discretion of the put buyer—in effect, indemnifying the put buyer from financial loss on Cisco’s shares. (The “cash-secured” part of the name simply means that we post cash for collateral equal to that of the price at which we are promising to buy shares.)



In return for this promise to buy the stock, I received a cash premium up front.



The careful reader will immediately notice that the transaction I have described is exactly the same as the one an insurance company enters into for a customer who wants to insure some private property. The insurance company receives a premium up front and promises to indemnify the asset holder against any loss he might suffer over the term of the insurance policy.



In the case of Cisco, I took the role of an insurance company and indemnified the holder of Cisco shares against a financial loss in case the shares dipped below the price at which I promised to buy them—$19 in this instance.



In thinking about possible investment outcomes, I knew Cisco would either be trading above or below $19 at the expiration of the contract (Oct. 24, 2011). In the case of the former, I would simply realize my premium income and have no further obligation. In the case of the latter, I would have to purchase the shares, but my “effective buy price” would be reduced by the amount of premium I had received.



For this investment, the economics worked out such that if I did not have to buy the shares, I would generate a return of around 10 per cent over the six-month term of the contract … and if I did have to buy the shares, I would be effectively buying them at the cut-rate price of $17.30. This seemed like a “heads you win, tails you win” situation, so I entered into the transaction.



Anatomy of an option investment, part II Time passed and the equity market, concerned about sovereign debt problems domestically and in Europe, sold off.



Cisco’s market value decreased too, despite some encouraging organizational changes that made me even more certain I was right about the company’s potential. When my put contracts expired in late October, the company was trading for around $17.50, which was below my $19 strike price, but still above my effective buy price of $17.30.



The stock had dipped even lower during the summer, and usually this kind of a situation drives an option speculator into a frenzied panic. But for me, it was an opportunity to increase my exposure to this investment rather than a reason to worry.



The difference between speculators and investors is that the former has no idea of the value of an asset, so is simply hoping for it to move this way or that. An investor, on the other hand, understands what the value of an asset is and puts capital at risk to win the difference between the market’s (mis)perception and his own understanding of intrinsic value.



When my sold put options expired on October 24, I received the Cisco shares, paying a net $17.50 for them. At that point, I could have simply sold my stock and pocketed a (measly) 20 cents per share gain on the position. Instead, what I did was extend the original position by selling a covered call on the Cisco shares we now owned.



A covered call is actually an equivalent position in terms of economic risk and potential return as a cash-secured put. As such, selling the covered call simply allowed me to extend the duration of my original bet a little longer while also receiving an even lower effective buy price on my Cisco shares. My effective buy price went lower, because I again received premium income when I sold the covered-call contracts.



When I sold the covered calls, I had a number of strike prices and expirations from which to choose. I finally settled on one when I calculated my expected maximum return and annualized maximum return given my new effective buy price.



I went with the 18-strike covered calls expiring in April 2012. I chose this because it gave me the highest annualized maximum return—10.9 per cent—and exposed me to Cisco’s downside risk for the shortest amount of time (the 10.9 per cent annualized return is actually the return of the investment as a whole—including the initial cash-secured put “leg” of the investment—but does not include a few cents worth of dividend that I have the right to receive as a holder of the shares).



So, in a little over a year (from February 2011 through April 2012), I stand to generate capital returns of about 11 per cent, even if Cisco’s share price at the end of the period is the same as it was when I initiated the investment! Not a bad result in a crazy market like the one in which we find ourselves now.



Options in a balanced portfolio Even high-yielding dividend stocks do not often pay over 10 per cent per annum. Yet, by using options, you can see how I have been able to create my own high-yielding dividend-paying stock out of a low-yielding tech giant.



When I think about what role options can play in a balanced portfolio, one of the first things my mind jumps to is income generation. As you can see here, selling cash-secured puts and covered calls can be a sort of substitute for dividend-paying stocks or high-quality corporate bonds.



This does not mean that one should start selling calls willy-nilly on any old stock. But covered calls can make a big difference in a conservative investor’s portfolio if used correctly and conservatively.



Erik Kobayashi-Solomon is editor of OptionInvestor at Morningstar

 
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