Picking the Right Income Play for 40% Annualized Gains
Over the past two weeks, we’ve taken a look at a few different covered call scenarios that have the potential to yield very attractive annualized gains, while actually reducing the amount of risk that a typical investor would be forced to accept.
On March 12, I explained how to make a 30.7% annualized rate of return buying Big Lots (NYSE: BIG) and selling the BIG April 35 Calls. BIG traded modestly lower last week as the market pulled back. The stock still remains above our strike price, however, which means that we should realize the maximum profit for this trade.
Our next example was a covered call trade on Family Dollar (NYSE: FDO). We discussed the difference between in-the-money calls and out-of-the money calls. Basically, selling out-of-the-money call options allows for a larger annualized return, while selling in-the-money calls gives investors more risk protection.
Today, as promised, we’re going to discuss different expiration dates and the reasons why you’d want to choose a short-term option contract or a longer-term contract. For our example, we’re going to use Blackstone Group (NYSE: BX). This private equity corporation has been in a strong bullish trend as the company benefits from a rebound in the real estate market.
If you don’t know the company, Blackstone is a private equity group that manages a number of different investment funds. They make money by charging their investors management fees and incentive fees on the investment portfolios, and they also invest their own money alongside investors.
Lately, Blackstone has been buying up literally billions of dollars worth of distressed residential properties across the country. They have been particularly active in my home town of Atlanta, Ga., and we have already seen a significant bump in home prices as a result of the extra demand.
I’ve been waiting for a good setup in Blackstone, and with the stock taking a mild breather and trading right at a popular strike price, this looks like a great opportunity.
Picking the Right Expiration Date
With Blackstone trading very close to $20 at the time of this writing, and the at-the-money premiums at an attractive level, it makes sense to sell the $20 calls for our covered call position. But should we take the April calls, or look further out and sell the May contracts? To figure out the answer, let’s run the numbers on each situation:
Scenario 1: Selling the BX April 20 Calls at $0.73
At the time of this writing, BX was trading at $20.08 and the April $20 calls were offered at $0.73. Of course, the prices may change a bit between the time of writing and when this hits your screen. But barring any unexpected event, you should be able to get an execution close to these prices.
- If we buy the stock at $20.08 and sell the calls at $0.73, our net cost is $19.35.
- If the stock stays above $20 through expiration, we book a $0.65 per share profit ($20 sale price less our $19.35 net cost).
- This represents a 3.36% return in about a month.
- Annualized, this nets out to a 40.3% rate of return.
With this scenario, we’ve got a very attractive rate of return — and a decent amount of protection. Blackstone has to drop $0.74 for us to take a loss on the position — that gives us roughly 3.7 percentage points worth of protection, which is helpful over a month-long period.
Now let’s take a look at the numbers for a call option with a little more time built in.
Scenario 2: Selling the BX May 20 Calls at $0.95
At the time of this writing, the Blackstone May $20 calls were bid at $0.95.
As a general rule, the more time left until expiration, the higher the price of the option contract. This is because there is more time for the underlying stock to move — which gives the option contract a higher potential value at expiration.
So in this instance, May calls are bid $0.22 higher than the April calls to account for the 28 additional days between the April and May expiration dates.
Running the numbers on this covered call opportunity we get the following results:
- If we buy the stock at $20.08 and sell the calls at $0.95, our net cost is $19.13.
- If the stock stays above $20 through expiration, we book an $0.87 per share profit ($20 sale price less our $19.13 net cost).
- This represents a 4.55% return over a roughly two-month period.
- Annualized, this nets out to a 27.3% rate of return.
Notice that our total nominal return for the trade (4.55%) is higher than the 3.36% return which we receive for the April calls. In this instance, we are getting compensated for the additional time that we tie up our money in the trade. However, when you calculate the annualized rate of return, we are actually getting paid a lower rate by using the May contracts. Let’s now take a look at why an investor might pick one of these contracts over the other.
Which Option to Take
Even though the April contracts offer a higher rate of return, there are good arguments to be made for both of the scenarios in question.
An investor might pick the May calls for the following reasons:
1. The opportunity to reinvest the capital when the April calls expire may be uncertain. So an investor might opt to take the 4.55% return over two months to allow the market environment to become more certain.
2. Transaction costs could offset the higher rate of return from the April calls. Taking longer-term trades may be more profitable as a means to avoid high commissions. (Note: If this is true, you may want to consider using a different broker with lower commissions.)
On the other hand, the April calls would be more attractive to most investors because:
1. The higher annualized rate of return obviously helps compound gains more quickly, leading to more profit over the life of the account.
2. In today’s market, there are plenty of great opportunities to find new covered call setups. So when the April calls are exercised, we should have a very good chance of finding more attractive setups to plow the capital into.
As a general rule, option contracts “decay” or lose value more quickly as they approach the expiration date. So for this reason, I typically like to set up covered calls that expire within a four-to-six week period. This gives us the best overall rate of return — assuming we are able to continue to find new covered call trades to put into play when our short-term calls are exercised.
On a daily basis, I run a number of screens to identify stocks with good bullish entry points. I then take a close look at the option contracts that are available to find covered call setups that have strong rates of return.
I’ll be back in a few days to discuss a new covered call opportunity. In the meantime, I would like to hear from you! Have you been taking advantage of the recent recommendations? Is this a strategy you would like to implement in your portfolio? What questions can I answer about how the strategy works or how I come up with individual trades?
Send your emails to Editors@ProfitableTrading.com and mention this article on covered calls. I look forward to hearing from you!