1 How To Generate Monthly Cash Flow And Purchase Stocks At A Discount Using Two Low-Risk Option Strategies Covered Call Writing and Selling Cash-Secured Puts Hosted by: Dr. Alan Ellman President of The Blue Collar Investor Corp. www.thebluecollarinvestor.com alan@thebluecollarinvestor.com www.thebluecollarinvestor.com
Strategy Overview Sell call and put options to generate monthly cash flow Sell OTM puts to buy stocks “at a discount” Sell OTM call options to enhance returns for a buy-and- hold portfolio Use both covered call writing and put-selling to develop a multi-tiered option selling strategy Zero-dollar collar to protect low cost basis stocks www.thebluecollarinvestor.com 2
Three Essential Skills Stock or ETF selection Option selection Position management www.thebluecollarinvestor.com 3
Definitions Call option- Gives the holder the right, but not the obligation to buy 100 shares of stock at a fixed price by a specified date. Call options will be used in the PCP (put-call-put) strategy Option- A contract that gives the holder the right, but not the obligation, to buy or sell 100 shares of stock at a fixed price (called the strike price) by a specified date (called the expiration date). It is the right to execute a stock transaction. Put option- Gives the holder the right, but not the obligation to sell 100 shares of stock at a fixed price by a specified date. www.thebluecollarinvestor.com 4
“Moneyness” Of An Option Relationship of the strike price to the price of the stock Puts (Stock $/strike $) Calls (Stock $/strike $) OTM ($32/$30) ATM ($30/$30) ITM ($28/$30) OTM ($28/$30) ATM ($30/$30) ITM ($32/$30) www.thebluecollarinvestor.com 5
Option Premiums In Relation To Stock Price Premium = intrinsic value + time value Intrinsic value = amount ITM (only for ITM strikes) Time value: Total premium – intrinsic value All premiums consist of time value only for ATM and OTM strikes www.thebluecollarinvestor.com 6
Preview Example For Calls Purchase 100 shares of Company XYX @ $48 per share = $4800. Sell an option: sell someone the right to buy these shares for $50 per share during the next month. You are paid a premium of $1.50 per share = $150. This is a 3.1% 1-month return = 37% annualized. www.thebluecollarinvestor.com 7
PREVIEW SCENARIO I At the end of the month, the stock price is less than $50; your shares are NOT purchased. You keep your 3.1% 1-month profit and are free to sell another option. www.thebluecollarinvestor.com 8
PREVIEW SCENARIO II At the end of the month, the stock price is above $50 per share and your shares ARE purchased. You now make an ADDITIONAL $200 on the sale of the stock. Total 1-month profit is $350 = 7.3% 1-month return = 87% annualized! www.thebluecollarinvestor.com 9
Real Life Trade With PRLB 9/23/13: Buy 100 x $78.10 Sell 1 x October $80 @ $3.30 = initial 1-month return of 4.2% 10/8/13: BTC $80 call @ $0.45 (slightly above the 10% guideline) 10/14/13: STO $80 call @ $1.40 (“hitting a double”) for an additional $95/contract credit 10/18/13: Allow assignment as stock is trading above $80 and there was an upcoming earnings report on 10/31/13 10/19/13: Shares are sold for $80 for an additional $190 per contract (bought @ $78.10) Total profit = $330 + $95 + $190 = $615 = 7.9%, 1-month return WWW.THEBLUECOLLARINVESTOR.COM 10
PRLB: 1-Year Chart WWW.THEBLUECOLLARINVESTOR.COM 11
PRLB: 1-Month Chart WWW.THEBLUECOLLARINVESTOR.COM 12
Summary Of Principles, Rules And Guidelines Used Stock selection using fundamental and technical analysis as well as common sense principles Option selection based on market assessment, chart technical and risk tolerance Exit strategy execution using 20/10% guidelines Expiration Friday decision based on earnings report rule WWW.THEBLUECOLLARINVESTOR.COM 13
Preview Example For Puts Stock BCI is trading @ $75 The out-of-the-money $72.50 put is selling for $2 for a 1-month expiration We deposit $7,050.00 into our cash brokerage accounts per 100 shares of obligation We sell the put option for $200 per 100 shares of obligation This option premium is ours to keep no matter what transpires by the end of the contract We are now obligated to buy BCI shares @ $72.50 per share should the option buyer choose to exercise the options Our initial profit from the put sale = $200/$7050 = 2.8% (less trading commissions) This annualizes to a 34% return www.thebluecollarinvestor.com 14
PREVIEW SCENARIO I If the price of BCI remains above the strike price (agreed upon sales price of $72.50), the option buyer (holder) is not going to elect to exercise the option and sell shares to us at a price lower than the current market value. Option will expire worthless, we will have generated our 2.8%, 1-month return and the cash is now freed up to secure another put sale the next contract month. www.thebluecollarinvestor.com 15
PREVIEW SCENARIO II Price of BCI does drop below the $72.50 strike price in which case the option will be exercised and the shares sold to us. The cash previously deposited into our brokerage account is used for this purchase. The cost basis we now own this stock at is $70.50, the $72.50 we paid for it less the $2 put premium we generated from the original option sale. At this point the put seller who is now the share owner can take one of the following paths: Sell the stock Hold the stock long term Write a covered call on the stock (giving the option buyer the right to buy these shares from us) to generate additional income www.thebluecollarinvestor.com 16
3-Pronged Approach To Creating A High-Quality Watch List Fundamental Analysis: Earnings and revenues Technical analysis: Reading a price chart Common sense principles (diversification) www.thebluecollarinvestor.com 17
Premium Stock Screen www.thebluecollarinvestor.com 18
Premium Watch List www.thebluecollarinvestor.com 19
Option Selection: “Moneyness” And Expiration (1-month) www.thebluecollarinvestor.com 20
Covered Call Writing Returns www.thebluecollarinvestor.com 21
Put-Selling Returns www.thebluecollarinvestor.com 22
Factors That Influence “Moneyness” Decisions Identify our goal Overall market assessment Chart technicals Personal risk tolerance Calculations meet our initial goals (2-4%/month) www.thebluecollarinvestor.com 23
“Moneyness” For Puts First establish goal (income only, buy @ discount, use with ccw) *OTM- Most conservative ($32/$30) ATM- More aggressive ($30/$30) ITM- Most aggressive ($28/$30): exercise most likely www.thebluecollarinvestor.com 24
“Moneyness” For Calls OTM- Most aggressive ($28/$30): highest potential returns ATM- Aggressive: highest initial returns ($30/$30) ITM- Most conservative ($32/$30) www.thebluecollarinvestor.com 25
Integrating Both Strategies: PCP Strategy www.thebluecollarinvestor.com 26
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First Q&A About 15 minutes www.thebluecollarinvestor.com 29
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15 minute break www.thebluecollarinvestor.com 35
Portfolio Overwriting Enhance the returns of a buy-and-hold strategy To increase by 6% per year, our goal is ½% per month Use out-of-the-money strikes to allow for share appreciation www.thebluecollarinvestor.com 36
Advantages Generate a constant, guaranteed monthly cash flow Downside protection in bearish markets Most retail investors are granted this level of trading approval Can be used as an additional monthly source of income www.thebluecollarinvestor.com 37
Disadvantages Early exercise may result in tax consequences Share appreciation is limited by the strike price Learning curve Modest time commitment www.thebluecollarinvestor.com 38
Why Is Early Exercise So Rare? Call buyer can keep cash in an interest-bearing account until the last minute Call buyer exposed to greater risk because stock price > option price Loss of time value of option- call buyer makes more money selling the option www.thebluecollarinvestor.com 39
What If Stock price > Strike Price By Expiration Friday? Easy to avoid exercise and sale of shares Roll the option: buy back current month option and sell the next month option prior to 4PM EST Roll out- same strike Roll out and up- higher strike www.thebluecollarinvestor.com 40
Early Exercise And Dividend Distribution Ex-dividend date close to expiration Friday Call strike is in-the-money (lower than stock price) The dividend is > time value of the option www.thebluecollarinvestor.com 41
How To Avoid Early Exercise Access ex-dividend dates www.dividendinvestor.com Sell option the day after the ex-date Sell a 2-month option www.thebluecollarinvestor.com 42
Ex-Dividend Date For AXP www.thebluecollarinvestor.com 43
Guidelines For Avoiding Early Exercise If the ex-date is in the 1st week of a contract, sell the option the next day If the ex-date is later in the contract, sell a 2-month option after expiration of the previous contract www.thebluecollarinvestor.com 44
Assumptions For Practical Application Long-term buy-and-hold portfolio with shares at a low cost basis Goals to generate higher returns and avoid exercise Roll options if strike is ITM by expiration Sell options the day after the ex-dates in the 1st week of a contract Sell 2-month options if later in contract Our goal is an additional 6% per year www.thebluecollarinvestor.com 45
Home Depot: Ex-Date www.thebluecollarinvestor.com 46
Home Depot: 1-Month Options Chain www.thebluecollarinvestor.com 47
1-Month Returns $41/$8044 = 0.51%, about ½% Share appreciation potential to $83= $83 - $80.44/$80.44 = 3.1% www.thebluecollarinvestor.com 48
Home Depot: 2-Month Options Chain www.thebluecollarinvestor.com 49
2-Month Returns Goal is now 1% to annualize to 6% Goal is about $0.80 Choices include the $82.50 strike @ $1.06 and the $85 strike @ $0.44 With multiple contracts use 1/2 of each to average to 1% If a single contract favor the lower goal for less need to roll the option www.thebluecollarinvestor.com 50
Summary Portfolio overwriting is a low-risk way of enhancing portfolio value In non-sheltered accounts, avoiding exercise is important if the cost basis is low Dividend distribution is the main reason for early exercise Covered call writing limits share appreciation to the strike www.thebluecollarinvestor.com 51
Using a Zero-Dollar Collar to Protect Low Cost Basis Stocks www.thebluecollarinvestor.com 52
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Summary to Master Option-Selling Must master all 3 required skills Stock selection: (fundamental analysis, technical analysis, common sense principles) Option selection: (“moneyness”, expiration date, returns meet goals) Position management: (bullish and bearish scenarios) www.thebluecollarinvestor.com 54
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Covered Call Writing And Put-Selling 62 Covered Call Writing And Put-Selling Generate Monthly Cash Flow using Two Conservative Option Strategies Hosted by: Dr. Alan Ellman President of The Blue Collar Investor Corp. www.thebluecollarinvestor.com alan@thebluecollarinvestor.com www.thebluecollarinvestor.com