You probably know the old proverb that has something to do with giving away fish vs. teaching the skills necessary to catch them.
With that concept in mind, we are going to talk about how to catch fish so that you can feast upon them whenever you want. (And if you don’t like fish, then substitute “income” or “gains” for the word fish, and this should be more interesting to you.)
If you buy a call option long and you are correct about the stock in terms of the direction of its next move, the magnitude of the move, and the timing of the move, then you can do quite well. When you can get all the variables correct, it’s a quick way to make a high-percentage return.
However, once you realize that the vast majority of options held until expiration will expire out-of-the money (i.e., worthless), it is a statistically better decision to sell options to other people rather than buy them. But selling naked options is risky because of unbounded liability, so the conservative investor should sell covered options instead.
Take a Bite Out of These Juicy Option Premiums
Let’s look at a stock everyone knows but one where investors are probably more accustomed to spending money than collecting it: Apple (NASDAQ:AAPL).
Few would argue that Q4 is likely to be the best quarter in the company’s history. If you’ve spent any time in the malls this season, or if you have any teenagers in your sphere, then you know the only gifts they really want are iPhones, iPads, iPods and Macs.
Now, let’s imagine you own 100 shares of AAPL. You have a few choices:
Choice No. 1
If you believe AAPL will not sell many products in Q4 (because of supply problems, lack of demand, external factors like the Euro crisis, etc), then you could just sell your shares today and avoid the next earnings release in January.
Choice No. 2
If you believe AAPL will have a blowout quarter, then you could just hang on to your shares and hope you’re right and that the hype for record-setting profits hasn’t already been factored in.
Choice No. 3
If you’re not sure, then you can hold on to the stock but sell weekly call options against your shares. This option will put a cap on your upside but will also generate weekly income for you.
As I write this, AAPL is trading around $395 a share. Here are a couple of covered-call ideas for different kinds of investors, generated by BornToSell.com:
APPL Trade 1: The Conservative Case
You are worried about macro factors like the Euro crisis getting worse in the next two weeks. So, you want to keep your exposure short-term, you’d prefer not to take earnings risk on the Jan 17 earnings announcement, and you would like to have more downside protection.
You could do one of these, which are 15 points in-the-money (i.e., the strike price is below the market price of the stock):
- Sell the Dec Week Two $380 strike for $15.50. Annualized return 15%
- Sell the Dec (monthly, expires Dec. 17) $380 strike for $17.35. Annualized return 21%
APPL Trade 2: Middle-of-the-Road Case
You are willing to take more equity risk in AAPL in exchange for higher income. You are a long-term holder of the stock, but want to protect your position in case the company doesn’t live up to hyped expectations during next earnings.
You’ll sell at-the-money options in the short term, but in-the-money options around earnings.
- Sell the Dec Week Two $390 strike for $7.55. Annualized return of 51%
- Sell the Dec (monthly, expires Dec. 17) $395 strike for $7.15. Annualized return of 55%
- Sell the Jan (monthly, expires Jan. 21) $380 strike for $26.50. Annualized return of 25%
APPL Trade 3: The Aggressive Case
You only sell out-of-the-money calls (i.e., those with a higher strike than the stock price) on AAPL because you are bullish that it will rise from where it is today. You want to leave yourself lots of upside around earnings.
All of these are out-of-the-money, and the returns shown are assuming the stock is trading flat at $395 by expiration day. Should the stock be above $395 at expiration, your returns will be higher than shown:
- Sell the Dec Week Two $405 strike for $1.10. Annualized return of 22% (if stock flat)
- Sell the Dec (monthly, expires Dec. 17) $405 strike for $3.10. Annualized return of 24% (if stock flat)
- Sell the Jan (monthly, expires Jan. 21) $420 strike for $7.85. Annualized return of 15% (if stock flat)
And the nice thing about trading weekly covered calls on a stock like AAPL is that you don’t have to maintain the same outlook week to week. You can vary your “moneyness” (i.e., whether your option is at-the-money, in-the-money or out-of-the-money) each week as the world around you, as well as your expectation for Apple, changes.
But the main point is this: By selling covered calls on AAPL each week you should have plenty of fish to eat. Bon appétit!