With many stocks trading not only at 52 week lows, but at or
near historic lows, an interesting opportunity is presenting itself in the
market. What most stock brokers won't
tell you is that in addition to owning shares of a stock, you can also collect
monthly income on those shares of stock.
Collecting “income” or “rent” on shares of stock as it is
called is known as writing covered calls.
The easiest way I can explain this is that you are selling someone the
right, but not the obligation, to purchase your shares of stock at a certain
price within a certain period of time.
For this right you will collect a premium. That premium becomes your “income” or “rent” collected
on those shares of stock. There are 2
components that go into the price of an option; time value and intrinsic
value. The longer the time until the
option expires, the higher the time value.
The more “in the money” the option is, the more it will cost.
Options can be sold for the current month, the next month or
several months or years out in time. The
current month or “front month” options have the least amount of time value
associated with them. Options that are
sold with a year or more of time until expiration have the most amount of time
value associated with them. These are also known as LEAP options (Long-term
Equity Anticipation Securities). Equity
options always expire on the 3rd Friday of their expiration
month. If the price of the stock is
lower (out of the money) than the strike price of the option that you sold by
the expiration date, you get to keep the premium and your shares of stock. All “out of the money” options expire
worthless if they have not become “in the money” by their expiration date. If the price of the stock is higher (in the
money) than the strike price of the option that you sold by expiration, you
keep the premium and sell your shares at the strike price.
Options can be sold “at the money”, “in the money” or “out
of the money”. If you sell someone an
“at the money” option, it means that you are selling someone the right to buy
your shares of stock at or near the current value of the stock (ex. stock is
trading at $34.95 and you sell the $35 call option). Selling an “in the money” option means you
are selling someone the right to buy your shares of stock for less than its
current value (ex. stock is trading at $37 and you sell the $35 call option; $2
in the money or $2 of intrinsic value).
Selling an “out of the money” option means you are selling someone the
right to buy your shares of stock for more than its current value (ex. stock is
trading at $33 and you sell the $35 call option). Some traders buy “out of the money” options
in anticipation that the stock price will appreciate in value greater than the
strike price they are buying. Options
are sold at strike increments of $1.00, $2.50, $5.00 or $10.00, depending upon
the price of the underlying equity.
Selling covered calls does require that you request Level 1
options trading permission with your broker.
Many investors trade options because of the leverage and the fact that
options can produce higher percentage returns as compared to trading
stocks.
Now you are probably wondering why I just gave this long
explanation about options? The reason is
that there are some stocks that have been beaten down in price to the point
that a unique opportunity is presenting itself in the market. What if you could buy a stock and over a
period of a few years or less you could sell enough covered calls against those
shares to ultimately bring your cost basis to zero? This opportunity is happening right now.
I must disclose that this should be considered VERY risky
and speculative in nature since most of these stocks may have strong red
trends. Some of you may have heard me
talk about doing this with Ford (stock symbol F). I purchased shares of stock in F several
months ago and have been selling covered calls against my shares almost every
month since then. The idea is that over
the next few years I would sell covered calls each month, ultimately bringing
my total cost basis to zero. Let's say I
owned 1000 shares of F for $2.50 and each month I managed to bring in $0.10 by
selling the front month call option. In
25 months I would have collected $2.50 in premiums, bringing my cost basis to
zero. At this point I could stop selling
calls and just hold the stock in anticipation that one day it is trading around
$15 or $20 and I then sell for a huge profit.
Or, I could continue to sell options against my shares, bringing in a
little bit of income each month.
To me this all makes total sense. I can buy a stock and then one day I could own
it for free. The risk for me is
two-fold. The biggest risk is that F
could file for bankruptcy, ultimately making my shares of stock worthless or
the price drops to pennies a share and I am unable to sell call options. That is a risk I am willing to take. I would think that the Ford family has a lot
more to lose than I do and won't let this happen. The other risk is that I could sell an option
too close to the current stock price or the stock price jumps and my shares get
called away from me before I want them to. If it was looking like you were
going to get your shares called away you could buy back the options you sold, but
you would pay more to buy them back than what you originally sold them
for. That is the risk of selling
options.
I have been stalking a couple of stocks that I think are
setting themselves up for this strategy.
They are URE and UYG. Both of
these stocks are ProShares ETF's (exchange traded funds). UYG is an Ultra Financials ETF and URE is an
Ultra Real Estate ETF. Think of them
like a mutual fund that trades like a stock.
Two years ago UYG was trading at over $70 a share. Today it closed at $2.73 a share, its lowest
level ever. What is important to
understand is that this ETF is comprised of financial related stocks. The top 10 holdings in the fund include JPM,
WFC, BAC, USB, GS, BK, TRV, V, C and AFL.
The good news is that unless every stock in this fund goes bankrupt, UYG
could not go to zero. The bad news is
that many of these stocks could still go much lower, thus bringing down the
price of UYG. Based on today’s close,
had I bought UYG right before the close for $2.75 and immediately turned around
and sold the Feb. '09 $4 “out of the money” call option, I could have brought
in $0.25/share of income. Immediately I
would have reduced my cost basis by $0.25 to $2.50. Now, if I could do this every month for the
next 10-12 months without getting my shares called out I could own UYG with a $0.00
cost basis.
The other ProShares ETF that I have been stalking is
URE. It is an Ultra Real Estate
ETF. The top 10 holdings include SPG,
PSA, NLY, VNO, EQR, HCP, BXP, PCL, AVB, and VTR. URE closed today at $3.98 a share and it has
been as low as $3.07 recently. Today I
could have bought the stock and turned around and sold the Feb. '09 $6 “out of
the money” call option for $.20/share.
Obviously since URE is a $4 stock it would take a bit longer to bring my
cost basis down to zero. I feel that my
biggest risk is that I sell a call and then the stock jumps up enough in price
that I get my shares called away. Had I
bought the stock for $4/share, sold the $6 call option for $0.20 and got my
shares called away for $6/share, I would have still earned 57% on my trade ($4.00
purchase price minus $0.20 for selling covered calls equals $3.80 cost basis;
$6 sales prices divided by $3.80 cost basis equals 57% return).
There are not many opportunities that show up like this in
the market. This strategy and the risks
associated with it are not for everyone.
If you decide to trade this strategy or a similar strategy, please make
sure you fully understand all of the nuances associated with writing covered
calls as well as trading counter trend.
To make big rewards sometimes you have to take big risks. Only you can decide if it is for YOU!!!
