How To Turn A Losing Position Into A Profit
In our latest issue of Income Trader, we sold a covered call option on Blackstone Inc. (BX), a stock we were assigned shares of on June 17. For those of you who have been with us from the start, you likely remember that we used to accept assignment on the rare occasions it happened. And with so much extra volatility in the market pushing options premiums higher, it is a good time to pick this practice back up.
BX was trading below the strike price when the June 17 $95 puts expired two weeks ago, which means the shares were “put” to us. For every BX put option we sold, we were required to purchase 100 shares of BX for $95 each. To generate additional income on our shares, we sold a call on our BX position.
Call options can be sold at any time. In my opinion, it is best to sell calls on stocks that you own, a strategy known as “writing covered calls.” This reduces your risk because your options position is “covered” by the shares that you own. With a covered call, the risk is limited and can be fully understood in advance.
Today, I’m going to explain in detail how that trade will work for us.
Back on June 1, we sold the BX Jun-17 $95 Puts and collected a premium of $0.50 per share. When the put option expired on June 17, BX closed at $90.25. BX was put to us at $95 a share, which was the exercise price. The $0.50 premium we received when we sold the put can be subtracted from the exercise price. This means the cost basis of our BX position is $94.50.
Then, on June 22, we sold a covered call on BX for $3.10 per share, or an immediate payment of $310 for each contract. That reduced our cost basis down to $91.40.
BX has fallen as the market selloff has accelerated during the past few weeks. I believe that we might have more downside ahead, but I see far more upside than downside by continuing to trade BX.
In the long term, BX is a great company to own, especially at current prices. Its price-to-earnings (P/E) ratio — a commonly used measure of value — is 13.4, below the S&P 500’s ratio of 17.6. That means the stock is already undervalued compared to the rest of the market. And while we’ve seen an overall market selloff, Blackstone’s fundamentals remain unchanged from when we first recommended selling a put option in early June. And because we now own shares, we’ll also start to collect some additional income from the stock’s nice 5% dividend yield.
But the most important piece to this puzzle is market volatility. Traders are nervous right now. That’s obvious from the selloff we’ve seen over the past three months.
And they’re not wrong. There are quite a few factors at play — fears over a potential recession, record levels of inflation, rising interest rates, the continuing war in Ukraine, the ever present issues with the supply chain, etc. — all of which could have an impact on stocks.
We can see all of this in the market data.
The chart below shows the CBOE Volatility Index (blue line), more commonly known as VIX or the “fear” index, and the S&P 500 Index (black line). As you can see, stocks tend to fall when volatility, or “fear” rises, which has been the case this year. As a result, these two indices move in opposite directions.
In the past week, we’ve seen VIX fall back under 30, and while it has risen again over the past few days, it’s a more measured rise than the big spikes we’ve seen lately.
When volatility is high, we can expect to see higher options premiums, which means more income for us to collect when we sell a covered call. This strategy allows us to put our assigned shares to work for us until prices recover.
In fact, that’s why this strategy is so powerful: Even when the stock doesn’t move — or goes down! — you can come out ahead.
This isn’t just theory. It is possible to achieve positive results even when we select a stock that underperforms. In fact, when shares are falling, you’re better off selling covered calls than simply holding the stock.
Let me show you what happened in another covered call trade we recommended earlier this year. We opened a position in Macy’s (M) on January 28, and when our calls were exercised on March 18, shares were basically unchanged. Over that period, shares climbed slightly from $25.44 in January to $26.25 today, a 3.1% increase. That was fairly in line with the S&P 500, which was up 4.5% over that same time.
But our covered call trade in Macy’s returned a nice 18.5% gain.
How is this possible?
Even though our shares didn’t change much in price, we still generated a profit from selling options and collecting dividends. Essentially, while other investors sit back and hope the gains will come to them, we’re using covered calls to actively create the gains we want to see.
For every 100 shares of M that we owned, we collected $335 from selling two covered calls, as well as an additional $16 in dividends — in addition to $56 in capital gains. If we’d simply been HOLDING shares of M that whole time, we’d only have received the $16 and would be up a total of $97.
That’s right. By selling covered calls, we managed to make 3.5 TIMES as much on our Macy’s position as the people just buying and holding.
That’s not to say covered calls are risk-free — no investment is. But they can help us reduce risk, which is as important to consider as income. In this market, where safe income is tough to find, selling options on high-quality stocks could be among the best strategies available.
Of course, not every covered call trade results in a gain. But, in time, those positions — like the one we just took in BX — have the potential to deliver big returns. Every time one of our options expires worthless, it means we can write another option on the stock, capturing another big income payment. This is why we only recommend selling calls on high-quality stocks that we would be happy to own for the long term.