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Using Options to Increase Your Portfolio Yield
By: Cabot Heritage Corporation
Creating Yield in a Virtual Zero Interest Rate Environment
Using Covered Calls
We are living in an environment where it is virtually impossible to get yield in the traditional manner. The Federal Reserve has driven interest rates so low that traditional bank CDs or money market accounts returns are virtually zero. So how do we create yield in such an environment? One strategy that all investors can use is options.
There are two strategies any investor can use to create yield that far exceeds traditional avenues. These options strategies are Covered Calls and Writing Puts.
Many years ago, my grandfather owned a couple of Exxon Mobil ( XOM ) gas stations in downtown Chicago. He loved the company, and over the years he accumulated a couple of thousand shares of XOM. Upon his passing, each of his grandchildren received 200 shares. The options trader in me immediately went to work managing my newfound position, and I started selling covered calls.
A covered call is a strategy that consists of owning an underlying stock and selling an option against the stock. Since a call option represents 100 shares of the underlying stock, you can sell one call against each 100 shares of stock you own. Because you own the stock, your short call position is "covered" by the stock.
A short option position by itself (without the stock) is very risky, and requires a substantial margin balance. A short call on stock you own, on the other hand, is a very conservative strategy that requires no margin.
I would recommend a covered call strategy against virtually any stock an investor holds. In my mind, it's free money.
Let's dive a bit deeper into this strategy.
As of the close last Friday (June 7), XOM was trading at 91.50 and as an owner of 200 shares, I can sell two calls against my stock position to create some extra yield. For example, I could sell two July 92.5 calls for $1.50 each.
If XOM stays below 92.5 by the July expiration, I will collect $300 total ($1.50 x 100 for each contract)-a yield of 1.6% in just two months. If I an able to replicate this six times a year, I'll earn 9.6%.
If XOM rises above 92.5, I will be taken out of my 200 shares by the owner of the call. However, if that were to happen, I could simply buy my stock back if I wanted to, and start selling calls all over again.
Writing puts is a more complex strategy, but when broken down and understood, this can be a tremendous trading strategy, and a great way to create yield for all investors.
Let's start with what a put is. A put is a contract between two parties to exchange an underlying stock, at a specific price, on a determined date. The buyer of the put has the right to sell the underlying stock at a set price. The seller of the put has the obligation to buy the underlying stock at the set price.
If you write a put, you are the seller of the put. This can be thought of in terms of insurance: you're the insurance agency, and the buyer of the put is the policy owner. If the owner of the put decides to exercise his right, you will be required to buy the stock at the predetermined price. However, as the seller of the put (the insurance agency), you receive a premium.
Here's an example of this strategy in Apple ( AAPL ) , which closed trading last Friday at 442. I feel comfortable buying AAPL stock at 400 so I would look to sell the July 400 puts for $3.50.
If AAPL stock price stays above 400 on July 20 (when the options expire), I will collect the $350 premium by selling the put, a yield of 0.79%. If I did this six times a year, I would create a yield of 4.74%.
There is risk associated with this trade: if AAPL dropped below 400, I would be required to buy AAPL shares at 400. But as I said earlier, I am comfortable buying AAPL at 400, which is a 10% discount to where the stock is currently trading.
This is a strategy many traders/investors use to enter a stock at a predetermined price. If I feel that AAPL is overvalued at its current price of 442, but am comfortable buying the stock at 400, this is a great way to buy the stock at that level if the price drops. And if it doesn't, I still collect the premium and can always sell another put later on.
In conclusion, there are countless ways to use options to create yield. Covered calls should be in every investor's playbook. And writing puts, which are a bit more risky, is a tremendous strategy to enter a stock at a good price and create yield.
Your guide to successful options trading ,
Analyst and Editor of Cabot Options Trader