Single Malt Scotch, Dorito's Loco's Taco's and Covered Calls
Addiction can be a serious b!#*h... only if you are addicted to the wrong things however. That was my thesis statement... hope you like it.
I am a financial advisor and I have three addictions. I love a nice glass of single malt scotch, the new Dorito's Loco's Taco from Taco Bell and Covered Calls. Since we are here to talk about finance, investments etc. let's center our discussion on the covered calls. If you have not had the taco's I would encourage you to try them pronto. Feel free to comment on your favorite adult drink as well. It's always fun to try new things.
My addiction started like most, with a shady character convincing me to play hooky and smoke cheap menthols while ditching art class. I was referred by a CPA I know, to a gentleman retiring from a big hotel chain who needed some advice. We met, decided to do a plan and during our discovery meeting he told me his net-worth was around 3 million but 1.2 million of it was in company stock. This was stock awarded to him throughout his tenure with the Hotel Company and came in the form of options, restricted stock and stock he owned outright. When I saw the mix of his investments I pointed out the risk of being so heavily weighted in one area and we decided that we would use laddered covered calls to reduce his position over time, increase his yield/income from the investment dramatically and lower his risk. Last year we finally had the last of the stock called away. It only took 7 years but we increased his return on that stock by 5-6% every 6 months for the last 7 years. Since then I have found that introducing this idea to potential clients has been the single most valuable tool I have to differentiate myself from the herd and it’s extremely basic.
Covered calls are a very safe way to increase the Alpha of a portfolio. For the beginners and individuals who have never used a covered call let's give you a brief example. Since Taco Bell has created the best taco ever made in human history let’s use the parent company YUM Brands (YUM) as the example.
As of the writing of this article YUM is trading at an even $67 per share. I like to do 6 month covered calls so I looked up the Option premium for an October call at $70. That means the exercise price of the option is $70. If the stock goes to $75 the person holding the option gets to buy it from you at $70. For that right they pay you a premium. In this case the premium is $3.
You purchase options in the form of contracts which are made up of 100 share blocks of the stock so in this case we are talking about an even $6,700. Since I am selling somebody the right to buy my 100 shares at $70 I am entitled to a premium. This premium is $300 ($3 per share). To determine the return on this you take the $300 and divide it by the value of the holdings which in this case is $6,700. When you do that calculation you will see a yield of 4.4%. The current dividend for YUM is 2% annually. Since we are only looking at the next six months that means you have a yield of 1% for dividends and 4.4% for the options premium for a total 6 month yield of 5.4%. If you do this twice a year you have an effective yield of 10.8% on a relatively safe large cap holding.
In a down market you lower your basis in the stock essentially every six months. This means you lower your risk on the investment you made, every time you collect the premium. It’s important to note that if you’re stock holding crashes you should consider carefully where you sell your next covered call. You could sell lower than where you bought originally if you pick an option price that is lower and the stock rebounds back to where you bought it. In other words you should have just bought some scotch.
Sometimes the stock gets called away and you have to sell it for $70. This adds an additional $300 in appreciation to the trade. So you get the $300 for the option premium plus $300 of appreciation so you get a total of $600. This is a total return of 8.8% on your money in 6 months or 17.6% annualized. I know that we give up the upside for the client when the stock goes through the roof. This strategy isn’t for all of your money. It’s for the more conservative blue-chip, dividend producing part of your portfolio.
As with good scotch, taco bell, and investment strategies it’s important to regulate your usage and make sure you are not overdoing it. I now only drink scotch a few times a month, I limit myself to 2 taco bell visits per month and I never have been one to put all of my eggs in one basket. I have found incredible success with covered calls and think you should try it for your portfolio.
Hope this helps