Creating Value with Covered Calls
Board: Value Hounds
...the sign on the door says Value but it's really more about opportunity and opportunities that can create value.
When investment style becomes intolerant and filters ideas without due diligence it becomes counterproductive. That's not saying an investor needs to step outside their comfort zone, but there is nothing better for the investing brain than trying to see the rationale underlying investments that are complete anathema to your own philosophy. It's like exercise--strengthens your core.
That's an absolutely lovely though from our dear feline leader! I'm a lot more price oriented than most value investors because I don't think its possible to assign true intrinsic value to any company and even if it were possible, it only speaks of the past, not of the future.
One fact is almost universally accepted, an investment is worth its discounted present value, the sum of all discounted future cash flows. While this is stated for the underlying companies, its perfectly true for one's stock holdings as well. There is nothing we can do now about future cash flows (except selling the stock) but we can influence the price we pay. Buffett says to wait for the fat pitch. Is there any other way? Yes, get a discount, sell covered calls when you buy the stock. The lower your cost basis the higher your CAGR.
Several objections will be raised: options are risky; your stock will be called away and you'll miss the opportunity to make the full profit; if the stock drops, you won't be able to sell it with the covered calls in place. All true up to a point but the real question is if selling covered calls will or not improve your results. Let's take them one at a time.
1.- Options are risky. True, but is selling covered calls riskier than just buying the stock? No, the amount of money you lose if the company declares bankruptcy is less if you sell covered calls since you have invested fewer dollars. There is also an opportunity cost which I deal with below.
2.- Your stock will be called away and you'll miss the opportunity to make the full profit. Yes, possible so we need to deal with it. Most of us have expectations for our portfolios. Pension funds, for example, work under the assumption of an 8% to 10% return. The market has a historic return. The interesting thing about selling covered calls is that you can calculate the CAGR of the deal should the stock be called. You can set that CAGR by selecting the strike price and the expiration date of the call. Sell the call with a CAGR that you like. if you don't like any CAGR, skip that stock. The point is that if you expect your portfolio to produce, say 12%, if you set the CAGR at 18% or higher, getting called is not really all bad, you get cash to make another deal.
3.- You won't be able to sell the stock with the covered calls in place. All you need to do is buy back the call. Since the call loses value as the stock drops, you'll make a profit on the call.
Having dealt with the objections, let's see how it works. The higher the discount when buying the higher your yield will be. You increase the call premium by lowering the strike price and by increasing the expiration date. But both also decrease the yield if called. It's a balancing act. You want a discount as high as possible but without lowering the CAGR below your minimum rate as explained above. The only way I have found to do this is to price a series of calls with various strike prices and expirations. I've found that the strike price should be somewhat higher than the stock's price and the expiration date between six month to a year in the future for best results.
An example using AIG at $48.28. I would likely pick a call with CAGR between 20% and 30%. Note that these are the longest expiration dates, Jan 2015 which have an extra advantage, since stocks fluctuate, likely you get a chance to buy them back at a good price way before the expiration date. The last time I bought AIG I sold covered calls at $3.15 and bought them back at $1.15 two and a half months before expiry which turned out to be a good thing because the stock took off after a small dip. By expiry the option was in the money and he stock would have been called. Anyway, the net effect was a 6.5% discount which you leverage for as long as you hold the stock.
Expiration Strike Premium Disc CAGR
1/18/14 57.5 0.35 0.7 137.0
1/18/14 55.0 0.82 1.7 101.2
1/18/14 52.5 1.68 3.5 76.0
5/14/14 57.5 1.50 3.1 47.7
5/14/14 55.0 2.25 4.7 40.0
5/14/14 52.5 3.30 6.8 34.0
1/17/15 62.5 2.10 4.3 28.5
1/17/15 60.0 2.64 5.5 25.4
1/17/15 57.5 3.40 7.0 22.8
1/17/15 55.0 4.35 9.0 20.4
1/17/15 52.5 5.45 11.3 18.4