It seems every asset class today has nothing to offer except volatility and disappointment. A few years ago, I advised clients who needed security and did not have market or risk management skills to put their money in a coffee can, bury it in the backyard or stuff it in the mattress. Chasing yield for income is never a good idea and many people got themselves into trouble buying seemingly cheep assets that are now expensive lessons. Their savings accounts have withered under the weight of such well paying but bust bonds of companies such as CIT and AIG.
As perverse, as it seems our strategy on advised accounts began to rely on one of the oldest management strategies – covered interest arbitrage. Sounds exotic? It really is not since it is only buying common stock and selling call options against it. There I said it – OPTIONS. Simple plain vanilla listed calls, not the rocket scientist’s of Wall Street kind that blow up every 7 years. If you are looking for Collars, Backspreads, Straddles or Going Naked stop reading now. There is nothing sexy about this strategy and everyone keeps his or her clothes on.
This strategy is actually the first true investment strategy I learned on Wall Street some 20+ years ago.
The process is simple and time tested: buy a stock and sell a call against it to earn premium. The details are important and change based on the investors needs in relation to risk and taxation. I can address the expected risk but the tax implications are between you and the IRS.
We began using this strategy in earnest several years ago in a Trust account that had an income beneficiary and remainder men. The income generated was not enough to provide the beneficiary with the amount of money they needed on an annual basis, as yields were too low. This resulted in the prospect of disbursing principal at the alarm of the remainder men. As is typical there is a natural tension due to the opposed nature of the interest of these two types of recipients. In order to address both their needs we embarked on a strategy of buying income producing (dividend paying) stocks and selling calls (for additional income) against the positions. The dividends when combined with the premium received from selling the calls was classified as income for the purpose of distribution and the result was preservation of principal when making distributions. All this meant was that in the end everyone was happy. I used italics because this gobbled-e-gook is important. Generating additional income, making more money, adding alpha, was our goal and it we achieved it.
I have taught this method to several old time investors as well as some youngsters. I have been fortunate enough to have gone to options trading school in Chicago and keep copies of Options as a Strategic Investment and Options Volatility and Pricing Strategy in my book shelf, they remain dusty as this simple strategy is best kept….. simple. Examples work best so here it goes:
Buy Stock CAT (Caterpillar) $67.50/share
Sell Call 08/20 strike $67.50/ $ 1.45/share
SSR (Stand still return) 2.15% u/a (Un-annualized)
Pricing based on the close of August 12, 2010
The SSR is simply the return if nothing happens but time moving forward - on options expiration day the price of the stock is the same as it is today. The return is unanalyzed because if annualized it would be over 150% and that is unrealistic. Remember we are simple folks doing a simple time honored tradition of making money. Several questions should come about and I’ll address some of the them today and others as we get to know each other better.
We use rules and stick to them based on the type of account. Low volatility accounts require some initial screening for: 1) payment of a substantial dividend, 2) a P/E that falls within reason, 3) stability of price and 4) large “stable” capitalization. As this is an income replacement strategy caution is necessary. It is important that the underlying stock is one we like for fundamental reasons in addition to its stellar technical qualities. After our screens find the initial stocks, we then look at the fundamentals. The options profit profile is the last cut and does not always work or remain attractive. Nevertheless, we do know we have a stock we like and can justify on a fundamental basis and offers additional income opportunity.
Looking a little closer at screening items 1 & 2 above, when it came to P/E (price earnings ration) my finance professor, Darrol J. Stanley, used to say buy under 18 sell over 28. At least that is what I remember from Business School and I am sticking to that rule. In this environment, P/E is problematic and sometimes I have to rely on the forward P/E. As with any indicator, it has its flaws but generally, P/E serves as a good “headline” statistic. The same can be said of the dividend. My friends who bought BP are still in shock as are too many pensioners. Dividends can change when a stock is at $20/ paying 2.5% or 0.50¢/dividend share is not the same when the stock is trading at $60/share or 0.83%. However, 2.5% is still 135 basis points over 3 month T-bill and 200 basis points over the 2 year Treasury while 0.83% is 68 basis points over the 3-month and 30 over the 2 year.
As for the other two items, pricing, term of option, in the money, etc, etc, well we can deal with that in the next postings.
Until then,
Send your comments, ideas and chump change to me at: AddingAlpha@consultant.com
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