In my previous post, I covered the basics of margin account and options. For this post, I’ll go over the strategies that I used to buy stocks cheaper, sell stocks at a higher price, making money without selling or buying the actual stock, and pay less taxes. To fully execute these strategies, the basic financial and option trading experience requirements mentioned in my margin account and options post must be met. So let’s dive in.
Writing a covered call option
I often use the covered call option strategy to make extra income for the current year or to improve future return of my investment portfolio. A really good time to execute this strategy is when a good dividend paying stock that I own have increased dramatically in value in a short period of time. For example, the Bank of Nova Scotia (BNS) common stock has increased over 35% in value year-to-date. At the time that I am drafting this post (December 14, 2016), the BNS stock price is about $77, it’s paying $0.74 per share per quarter, which is about 3.84% (=$0.74 * 4 /$77) in annual dividend yield. I will write a covered call option contract (1 contract = 100 shares), with a strike price of $84, expiring on January 2018 and collect about $2.00 per share in premium (or $200 in fees). If the option is exercised (that means I’ll have to sell my BNS stock at $84), I am more than happy to sell. I will be guaranteed an additional 15.53% (=[$84 + $2.00 + 4*$0.74 – $77]/$77) return on top of my current return in about one year when I factor in the price appreciation, fee collected and dividends. If the option is not exercised, it’ll be expired and worthless, I am still collecting my usual $296 (=4*100*$0.74) in dividends and $200 in free money from the purchaser.
Writing a naked put option
Sometimes, there are a few really great stocks that I wanted to buy, but it never seem to go on sale (the price of a stock drops by at least 15% by my definition) and I don’t want to pay the current price for those stocks. Enters the naked put option, it can help me buy a stock cheaper than the current price. For example, I think that The Coca-Cola Company (KO) is a great stock to own. However, it rarely reaches a price point that think is cheap enough to buy. Until recently, when the price of The Coca-Cola Company (KO) drops to about $40 per share (from a high of $47.13). At that point, I sold one naked put option contract with a strike price of $38 per share, expiring on January 2018 and collected about $2.25 per share in premium (or $225 in fees). If the option is exercised (that means I’ll have to buy 100 shares of KO stock at $38). I’ll be very excited to buy it because the price that I’ll be paying is only $35.75 per share (=$38 – $2.25, you get to reduce your average cost by the premium that you collected if the option is exercised), which is about a 24% discount from the highest price point of $47.13. If the stock never goes below the $38 mark at any time before January 2018, the option will expire worthless and I get to keep the premium of $225 without investing any money in KO.
Writing options just to collect premiums
When I am writing options, either naked put or covered call options, I don’t always want to buy or sell the stocks. However, I have no issue buying or selling the stock if the purchaser exercise the option, but I prefer just to keep premium for free. In that case, I’ll write naked put options that are at least 15% to 20% below the current price and covered call options that are 15% to 25% above the current price. I will be collecting a bit less premiums comparing to the options that I write with strike prices that are closer to the current stock price. If either option is exercised, I will be buying stocks even cheaper or selling stocks at higher prices and make more money. Recently, I bought 100 shares of Chipotle Mexigan Grill Inc. (CMG) at about $430 per share. After buying it, I wrote 1 covered call option contract with a strike price of $600 and an expiry date of January 2018. I collected about $1,600 (= $16 * 100) in premium. If the option is exercised, I will make an eye popping 43.3% (=[$600 + $16 – $430]/$430) for this investment. Otherwise, I get to keep $1,600 for free.
What are the risk associated with these strategies?
With any type of investment strategy, there is always risks involved. However, the risk can often be managed or mitigated. The rule of thumb that I use to executing these strategies are to select the stocks that have brand name recognition, have been paying dividends continuously (and a history of increasing dividends is even better), and good cash flow to pay dividends. The worse case scenario is that you’ll lose the value of the contract less the premium that you collected (= strike price * 100 – premiums). The same can be said for any investment, not just stocks. If a company has had brand name recognition, have been paying dividends for years and maybe even raising dividends every year, the chances for that company worth zero in value around one year of time is quite remote. Hence, my risk of losing a significant amount of my money is managed.
What are the tax implications
For the cases that the contract expired worthless and you keep the cash, the proceed will be taxed as capital gain, which means you only add 50% of the gain to your income to be taxed (in the year that you received the cash). In the case that the covered call contract gets exercised, 50% of the premium is taxed in the year that you received the cash and 50% of the gain from the stock sale is taxed in the year that you sell the stock. On the other hand, if the naked put contract gets exercised and both the transaction for the option and the purchase of the stock happens in the same year, you pay no tax and you just lower your average cost of the stock by the premium amount. If the transactions occurred in different years, 50% of the premium is taxed in the year that you received the cash and report a loss for 50% of the premium in the year that you buy the stock. The net effect is almost zero, but the government wants you to report the income in the year that you earn.
My two cents
For me, I’ve never purchased an option before. I only write options as I prefer to get cash from people instead of giving my hard earned cash away and hope that a stock price goes up or down within a one year period. The three main purposes for me to write options are: to buy stocks at a cheaper price, or to sell stocks at a higher price that will make me greater profits or getting free money when nothing happens. I think buying an option is more speculative and I let other people do it.
The options are there (pun intended). You just have to choose which path you want to take to build your wealth. Would you put this strategy to your investment toolkit?