Lemonade

I admit, it’s time-worn, but this kind of market reminds me of that old admonition to make lemonade out of life’s lemons.  Still, it’s worth noting the market corollary:

When the market hands you volatility, sell covered calls.

When I first traded options for my own account, I used to keep graphs of stocks and their options on semi-log graph paper, and go down to the Merrill Lynch Pierce Fenner & Smith office (yes, they did still have all those names on the letterhead) to watch the ticker tape and talk to my broker.

He was a real survivor, having been in the retail brokerage business in the Crash of 29, and somehow he stuck with it through the lean times that followed.  His client advice was simple:  Find several dozen companies you are willing to own for the long haul, and let their stocks pay you.

That obviously worked for dividend-payers, but what about the high-tech growth stocks?  It turns out those can pay you even more.

Take today’s darling, AAPL.  It’s dancing around $200 a share today, and if rumors of a new killer product are true, it could go much higher.  On the other hand, if it just gives up its gains since July, today’s $200 share may be trading for $135, much to the chagrin of today’s happy shareholders.

Of course, you could sell now, and take your profits.  Or you could sell an option to someone else to buy the stock from you for $200.

I see that the January $200 calls are selling for around $11 apiece.  Based on today’s price, that’s more than 5.5% (22% a year) in cold hard cash on an option with less than three months (87 days) to expiry.

So, what to do?  How about selling options on half the position?  That way, you’ll still participate if the stock screams higher, but get paid a double digit annual return (just over 10% on your whole position) if the stock price just sits there.

If the stock price heads south, your net worth will decline, but you’ll have the cash from the options to take a bit of the sting away.

I know lots of people are afraid of options.  To that concern, I’ll just point out that selling covered calls is the only option strategy that even IRA accounts are permitted to do.  That’s because owning stock and selling covered calls is considered to be safer than just owning stock.

With my own money, I like to buy really volatile stocks and sell options.  I follow some small biotechs, for example, that have drugs in the testing pipeline, but don’t yet have FDA approval.  Needless to say, they are pretty risky stocks.  They are also pretty volatile as a result.

One of them was trading under $5 a share last spring when I bought it and sold $5 calls with two months to run.  I got over $1 in option premium at the time.  Then the company announced very positive preliminary results, and the stock went flying up.  Naturally, my shares got called away, for a net profit of over 30% in two months.

Today, I own that stock again, but had to pay around $28 for it in the last purchase.  You’d think I might be crying over the “missed profits” between $5 a share and $28.  You’d be wrong.  Today’s $28 shares may well be called away from me in January for $30.  I got paid $3.50 for that option.

I also own a handful of others.  One got called away when the stock ran up to the $20 neighborhood from $4 – $5.  I bought it again for $18, and immediately sold $20 call options for about $2.50. The others are still cheapies, trading under $5 with occasional spikes into the $6 neighborhood.

I’m selling $5 calls on these babies for $1.20 to $1.40 per share, and usually only have to sell calls with two to three months left in them.  In other words, after a year passes, I’ve probably collected more in option premiums than I paid for the stocks.

I don’t feel any particular need to be invested in these companies forever, and I expect those that are really successful will get swallowed up by the mega-pharmas.  That’s OK.  Some will turn into a bust.  Not great, but OK.

I’m getting paid nearly 80% per year (or more) for their volatility when the stocks are trading for $5, and 40% per year when they trade for $20 or $30 a share.

Sure beats CD’s.

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