Warren Buffett, in a recent television interview, said that he was having a hard time finding stocks to buy these days. Carl Icahn seconded the motion a day later, saying the market was fully valued. What’s an investor to do?

While options are not magical devices that can create cheap stocks out of thin air, they can be used to tailor an investment portfolio’s risk and return profile, and this ability can be a great benefit in a fully valued market like today’s.

There are three simple option strategies that can help investors in a fully valued market:

  1. Protecting a portfolio from a market fall.
  2. Generating income by selling upside potential.
  3. Using the income strategy to subsidize the protection strategy.

Last weekend’s blog posting looked at choice number one. Today, let’s move onto selling upside potential. I’ll finish discussing the third choice later this week.

Selling Upside Potential
If the market is fully valued or “toppy,” by definition, it should not have much in the way of upside potential.

However, even if there is not much upside potential, the option market always prices options as if there were. (For a summary of why this is so, see the IOI feature Learning Options: How Option Prices Predict Future Stock Prices)

This inefficiency creates a great opportunity for intelligent investors. The market is paying something for a commodity (upside potential) that is worth nearly nothing, so an intelligent investor will sell that commodity. This is just the “Buy low, sell high,” rule reversed–starting with the “sell” part first, in other words. Calls are the options that represent upside potential, so our sell high, buy low strategy implies we should sell call options.

Using the IOI graphical conventions, here is what selling away upside potential would look like.

IOI representation of a sold call
(c) 2013, IOI, LLC

This image shows that I have sold (indicated by the red shading) a call option on Advanced Building Corp. (ABC) with a strike price of $55 / share and an expiration in one year. Let’s assume we get $5.00 for selling this call option.

Because we are receiving $5 in premium, we will realize a positive return as long as the option expires when the stock is trading for ($55 + $5 =) $60 / share or less. We realize the full $5 of premium if the option expires when the stock is trading for $55 or less, and no matter how far below $55 the shares are trading at expiration, we will never realize more than $5 / share.

The careful reader’s next question should be “What happens if I’m wrong about the value of the upside potential and the stock is trading at $100 / share at option expiration?” In this case, our losses would be ($100 – $55 – $5 =) $40 / share. Since the maximum income we can receive from this strategy is $5 / share, the prospect of losing $40 / share (or $4,000 / share, since stocks do not have a theoretical maximum price) is quite unpleasant.

Of course, the prospect of making this large of a loss is unpleasant to an investor, but it is also worrisome from the perspective of a broker. If the shares go up by so much, the broker has to worry about whether or not the investor has the ability to shoulder the loss or not. It is for this reason that brokers require payment into a margin account–to serve as collateral against an investor defaulting on losses.

For brokers, the two best forms of collateral in this case are 1) cold, hard cash, and 2) shares of ABC. In fact, from a broker’s perspective, if an investor holds shares of ABC, this is the best collateral, because even if the share price goes up very quickly, the broker always knows the position is completely covered. With cash collateral, if the stock price goes up very quickly, the amount of cash in the margin account may not be sufficient to cover the loss; if not, the broker will have to sell other shares and this whole process is a hassle.

Obviously, all of you who are in the know, know that what I am describing is a “Covered Call” strategy. Let’s assume that we bought shares of ABC years ago when it was trading for $30 / share. Here is how we would represent our profit and loss position from an IOI graphical perspective.

Unrealized Gain on ABC with a buy price of $30 / share
(c) 2013, IOI, LLC

Clearly, even though the stock has increased a lot in value over the years, if the stock falls below $30 / share, we are accepting a risk of loss. The area between $30 and $50 / share is an unrealized gain and we shade it in orange. This is meant to show that if the stock declines from $50 / share, we stand to lose out on some of our gains to date. Obviously, anything over $50 is more potential return for us.

Now, let’s overlay this risk / reward position with our sold call. In graphical terms, this is what our position looks like now:

Covered Call on ABC at a strike price of $55 / share
(c) 2013, IOI, LLC

This is starting to look a little like a circus, but it is really pretty simple. Let’s take it step by step.

Step 1: Sell the call option struck at $55 / share
Because we hold the shares, selling the call option simply removes any chance of us receiving upside over $55 during the life of the option. As such, we represent this region as gray–no exposure.

Step 2: Receive $5 in call option premium
When we receive the premium, we can think of it as changing the level at which our risk (red shaded region) begins. We originally bought the shares for $30; when we sell the call, we are receiving a “rebate” of $5, so we will not be worse off financially unless the shares fall below ($30 – $5 =) $25 / share. On the diagram, we show this as a step down in the red-shaded risk area.

Step 3: We might not end up owning the shares
Notice that if the option expires when the shares are trading above $55 / share, we will have to deliver our shares to the call buyer. As such, we may not end up owning the
upside potential of the shares a year from now. On the diagram, I use a mottled green area and ????? to represent the future ownership uncertainty.

There is one thing in particular to note about this diagram: Selling a covered call pushes down the level at which you risk realizing a loss, but it does not prevent you from realizing one. Some people sell covered calls thinking they have “taken profit” on a stock investment, and are shocked when the stock price falls heavily. After reading this, I hope you will be saved from this painful misunderstanding.

Now that we understand how to think about the risk and reward for covered calls, let’s look at a few rules of thumb regarding carrying out this strategy.

Rules of Thumb
There are three rules of thumb I like to use about covered calls:

  1. Don’t sell covered calls on a stock with huge upside potential or that you never want to sell
  2. Sell calls at a strike price as close to the market price as you can stand
  3. Shorter tenors are usually better
Let’s look at each rule of thumb in turn.
Don’t sell your favorite horse
If you bought a stock at $30 that’s trading for $50 and you think is worth $70, and this stock is your best growth idea in your portfolio, save yourself the mental anguish and don’t sell calls on the thing (unless you can make $20 / share on selling the calls!). Also if you have a particularly strong emotional attachment to a stock and like nothing more than gazing at your unrealized 1769% holding period return on the stock when you’re feeling blue, do yourself a favor and don’t sell calls.
Whenever you sell calls, keep in mind that doing so means you may wind up having to deliver your shares to someone else. There is a special feeling of misery that comes from realizing that your covered call investment successfully generated an extra 7% of returns when you could have enjoyed a 70% capital gain if you hadn’t sold the upside potential away (I know this from personal experience with a company called Lithia Motors LAD on which I successfully sold $10 puts for a 20% gain a few years ago–LAD is now trading for $70 / share).
The Right Strike is the Market Price
I know it feels terrible somehow, but the most efficient price at which to sell options is exactly at-the-money (ATM). Selling ATM means that you receive the maximum amount of time value possible for that option at that moment. If you sell a call option that is far OTM, you will probably not have to worry about having to deliver anyone your shares, but you will also not receive much money.
Selling an ITM option, on the other hand, will generate more cash inflow than if you sell ATM, but part of what you end up selling is unrealized gains. 
In short, the idea behind selling covered calls is to sell as much of the potential return as you can, and the maximum is exactly ATM.
Shorter Tenors are Better
This is a hard thing to quantify exactly. Selling longer tenor options will generate a higher dollar amount of premium. However, the amount of premium received per day until expiration is always greatest for shorter term options. For example, selling a one-year option might generate $5 compared to only $1 for a 30-day option. However, selling the longer tenor option, you make only $0.014 / day compared to $0.033 / day for the shorter tenor one.
As a rule of thumb (for my rule of thumb) I usually look at options with anywhere from six to nine months left until expiration, and usually come down on the side of the shorter. If you really think the market is in for a fall, maybe it is okay to lean toward selling the longer tenor option, but in general shorter tenors will give you a higher cash inflow per day.
Covered Call Summary
In a nutshell, we can say the following about covered calls:
  • Covered calls represent a nice way to generate a bit of extra income when you think the income received will more than offset any potential for gains a stock might have. 
  • Covered calls do not remove risk, but simply reset the risk to a lower level. 
  • The name of the game is to maximize the potential return you are selling away and this always occurs at-the-money.
Thinking about option strategies for an overvalued market and thinking back to the earlier posting about protective puts, do you think it would be better to sell calls on the index or on an individual stock in your portfolio?
If you said “individual stock” you are right.
Premiums of options on individual stocks are almost (never say never) always higher than premiums of comparable an index. This is just the flip side of the coin of the rule of thumb for protective puts: “Buy puts on an index.”
In the next article, we’ll review what I think is the best option strategy for a fully valued market–one that combines protective puts with covered calls.