by Robert Rapier, Investing Daily
Article of the Week from Investing Daily.
I use a number of tools to identify promising investment ideas. One of my favorites is Fidelity’s Strategy Ideas tool in the Options menu. This tool can quickly identify top candidates for many different types of option investing.
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You can select filters according to your outlook and risk tolerance, and it will highlight which strategies are most appropriate. Or if you already know what you want, you can go straight to the strategy.
Source: Fidelity Investments
Options for Beginners
Let’s quickly cover the basics, so everyone is on the same page. An option gives the right, but not the obligation, to buy or sell shares at a defined price and on or before a defined time. A person who buys a call option is buying the right to purchase 100 shares of stock. The person who sells a call is creating the obligation to potentially sell them.
Options define the price at which the trade would be executed (the strike price), the date by which the trade would occur (the expiration date), and the premium (the cost) of that option.
If you own 100 shares of stock, you can sell a call against those shares (for most publicly traded companies). Or, you can use a buy-write strategy to sell the call at the same time you buy the shares, which reduces the cost of the shares. But the call obligates you to sell your shares at some point in the future if the price is above the strike price.
Read This Story: Selling Covered Calls To Boost Your Income
I favor using covered calls as a way of boosting income and lowering my downside risk. But the caveat with covered calls is that the upside potential is capped. Once a stock rises above the strike price, you no longer benefit from the rise. You gave that up in exchange for the certainty of the premium. The person who bought the call was betting on a rise above the strike price, while you are hoping your shares don’t get called away.
Understanding the Returns
Let’s take a look at a small sample of the display if you click on Fidelity’s Covered Call icon:
Source: Fidelity Investments
Note that this screening tool is highly customizable. Although it displays a number of intriguing possibilities, you can specify that you only want to look at results for a specific stock. You can also customize the time frame until expiration.
Let’s take a look at the first entry to better understand how option returns are calculated. Vinco Ventures (NSDQ: BBIG), formerly known as Edison Nation until November 2020, is based in Pennsylvania. The company offers toys, plush, homewares, and electronics to retailers, distributors, and manufacturers through e-commerce channels. It also provides personal protective equipment to governmental agencies, hospitals, and distributors.
Last Friday the stock price closed at $5.16. At that time, you could sell a $10 call on BBIG and receive a premium of $0.75 share. What does that mean? If you own 100 shares of BBIG, you could sell someone the right to buy your shares of the company for $10, with that right expiring on July 16, 2021. You are going to receive $75 in cash for shares that were worth $516 at Friday’s close.
The “Stand Still Return” is how much you would make if shares expire at the price they are at today. If you entered a covered call position by buying 100 shares and simultaneously selling the call, then your net entry price is $5.16 – $0.75 = $4.41. The profit you make if shares don’t move is $0.75/$4.41, or 17%.
That is an extraordinary return for one month, but look at the “If-Called Return.” In that case, if shares are at or above $10 on July 16, your shares will be called away. You will receive $10 for them (plus the call premium, plus dividends if that is applicable) for a total return in this case of 127.27%.
So if you can make 17% in roughly a month if shares don’t rise, and potentially 127% if they do, that seems like a win-win. What’s the catch?
You only find high option premiums like this with very volatile stocks. Vinco Ventures was under $2 a share as recently as January, and it touched $2.10 in April. It could easily drop by more than $0.75 a share in the next month, at which point you would be at a loss position.
However, because the covered call lowers your cost basis, it’s a safer strategy than simply buying shares of Vinco Ventures. Shares will have to fall by 14.5% ($0.75/$5.16) before you are in a loss position if you sold the $0.75/share call against your shares.
That exercise should give you a feel for the pros and cons of selling covered calls. To be clear, I am not endorsing Vinco Ventures. I have done no due diligence on this company at all. I am merely demonstrating how the use of covered calls can impact your returns.
Caption graphic credit: A clip from photo by Nicholas Cappello on Unsplash. Full image:
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