By Eric Hale
It was big news a few months back when Apple Inc. (AAPL) announced that they were initiating a Dividend of $2.65 per share. The dividend was made official on July 24, 2012 – the Declaration Date. The dividend was paid on the Payment Date – August 16, 2012 – to all shareholders who owned it before the Ex-Dividend Date – August 9, 2012 – and held it through the Date of Record – August 13, 2012.
People who own stocks like to look at their portfolio balances every day to determine how much money they made – or lost – that day. Let’s be clear: you don’t make money or lose money until you sell the stock. If you bought APPL at $78.20 back on January 20, 2009, your value has increased, but you hadn't made any money until recently when they began paying a dividend.
As of August 22nd, 2012, if you have bought Apple stock ($656.46), you’ll be getting a dividend yield of 1.61%. That is slightly better than today’s 10-year treasury yield of 1.56%. Of course, the big difference between the two investments is that you can lose your capital investment if Apple stocks go down. (Of course, you could lose your capital investment in the 10-year treasury if the USA goes bankrupt, which is not impossible. But, the likelihood of that is not a topic to debate today.)
What options traders have known for a long time is that you can generate income from the equity using the trade known as a Covered Call. Today, you could sell the September 2012 $660 call – which expires in 30 days – for about $19.00. Let’s assume that Apple goes stagnant over the next year and we don’t see any significant changes in implied volatility, we could sell a similar option every month for about the same premium. We could generate $228 (12 month x $19.00). That is return of 34.73%. Throw in the dividend on top of that and you have 36.35% annual yield. That is a nice investment.
Now, what happens if the stock goes up and expires above the short call strike of $660? That means that you’ll have to sell your stock for $660. Since the price you paid was $656.46 and you collected a premium of $19.00 that means your cost basis is $637.46 ($656.46 - $19.00). Selling at $660 would generate a profit of $22.54 (assuming that you were called out in the first month.)
What about the down side? What happens if the stock price falls? Again, you don’t lose any money until you sell. But, you will see your asset value decrease. Your maximum loss is your cost basis of $637.46. (When the stock price is falling, try to explain that to your spouse: “We’re not actually ‘losing’ money, honey.”) Options traders know how to address that.
They buy puts.
Puts are insurance. They make money if the stock price goes down. They protect your investment. In exchange for that investment, you have to pay for that protection – just like insurance.
Today, you could purchase the April 2013 $650 strike put for about $64.00. That put expires 240 days from today. (You cannot buy exactly one year of protection because there isn’t a September 2013 series of options available yet.) Yes, $64.00 a lot of money but you have to realize that you have protection for the next eight months.
If you just buy the stock and the long put we have a trade known as the Married Put or Protective Put. The most the trader can lose in the married put is the difference between the put strike and the price paid for stock, plus the cost of the put.
Maximum Loss on Married Put = $70.46 (656.46 – 650 + 64.00)
That is a maximum loss of 10.7% (70.46/(656.46 + 64)), with unlimited upside. However, in order to make a profit you need AAPL to rise by more than the price of the put. So, you would need AAPL to be above $720.46 by September 2013 expiration. That is quite a move. It’s not impossible, but the odds are against you.
Can you put the odds on your side?
What if you combine the Married Put with the CoveredCall? That trade is known as the Collar Trade. There are multiple ways to enter a collar trade. If you are looking for a low maintenance trade, and really only want to focus on protecting your capital investment and collecting the dividend, you could also sell an April 2013 $660 call and collect $63.20.
To review, that trade would be: AAPL Stock at $656.46, buy an April 2013 $650 put for $64.00, and sell an April 2013 $660 call for $63.20. This gives you:
● A right to sell AAPL for $650 anytime between now and expiration.
● An obligation to sell AAPL for $660 if the call buyer choses to exercise the option, or if it expires above $660.
● The right to continue to collect the dividend as long as you own the stock.
The net cost basis on this stock is $655.66 ($656 + $63.20 - $64.00). However, since you have the right to sell the stock for $650, the absolute most money you can lose is $5.66 ($655.66 -$650), as long as you are in the trade. Assuming you can collect the $2.65 dividend, at least two more times between now and April expiration, that will lower you cost basis to $650.36, making your maximum loss $0.36. If you can collect both dividends and the stock expires above $660. Your maximum profit is $9.64 or a 1.48%. While that is not spectacular, it’s better than a sharp stick in the eye. It may be exactly what an investor needing to protect their nest egg is looking for.
An alternate approach might be to sell those calls on a monthly basis. Assuming that the investor chose that April 2013 put and selling monthly calls – as in the covered call example above – the trader would generate much greater returns.
Between now and April 2013 expiration there are 8 months. If the investor could sell those calls for $19.00 each month for the next 8 months, the net cost basis at the end of the trade would be $568.46 ($656.46 + $64.00 – 8 x $19.00).
In this case, your profit situation looks like this:
● Maximum profit is a gain of $91.54 ($660 - $568.46) or 16.3% profit in 8 months
● Maximum loss is a gain of $81.54 ($650 - $568.46) or 14.3% profit in 8 months
This sort of trade is not something that you can enter into out of the gate - there is no such thing as a free lunch. But, a nimble and educated investor can manage themselves into a trade like this. Imagine the situation where your best-case scenario is to make a 16.3% and the worst-case scenario is to make only slightly less profit at 14.3%.
This example was over-simplified and we made a few bold assumptions (i.e., AAPL is stagnant over the next 8 months, the implied volatility does not change, Apple continues to pay a dividend, etc.). In reality, things will change with AAPL. (The price of AAPL has already moved by more than $5.00 since I started writing this article.) However, this does demonstrate the power and versatility of the collar trade.
These are just a couple examples. Some traders are using weekly options. Others are using more long term options. Others are somewhere in between. There are benefits to each approach. It’s up to each individual investor to determine what is best for them.
But, there are people who have used the collar trade to manage into a situation where the options are:
- make a decent profit, or
- make slightly less profit.
This is how we teach people to trade at OptionsANIMAL.
Now, try explaining to your spouse that you cannot lose! (For my wife, it comes down to “Just trust me, honey. I got this.”)
Eric Hale is a master of the OptionsANIMAL trading method. At OptionsANIMAL he discovered how to trade successfully in any market condition. Today, he uses his knowledge to help other investors trade with success.