Many investors are scared of stock options. But there is no need to be. Options are just contracts, and much less complicated than when you buy or sell a house! Or take out a life insurance policy.
The most interesting option strategy for me is to sell a “covered call.” One reason I like it is because when you sell something, someone pays you money. I like to be paid money.
The call contract is an agreement, managed by the brokerage houses, under which the seller agrees to deliver stock at a certain price during a period of time. The buyer then has the right to buy that stock from the seller at that price during that time period. If they don’t, I will just get to keep the premium I was paid.
As an example, some years ago I bought 1,000 shares of Walgreens stock at $45 a share. The stock has been as high as $47 a share not long ago, but has dropped for reasons I’m not sure of, but it seems like CVS pharmacy is tough competition for Walgreens — and CVS is winning! In mid-February the stock was trading at just over $33.
But I liked the information in the Walgreens annual report, even if it’s not doing as well as CVS, and until recently the stock seemed under-valued to me. Plus it pays a dividend of 2.7 percent, which is pretty good in today’s economic world.
So for about two years I have been selling calls against the stock. The last call I “wrote” is the April 35, for which I received $1.25 per share. Since I own 1,000 shares of the stock, I sold 10 calls (each call equals 100 shares) and received $1,250.
I’ve done that same trade about six times over the past two years, and collected in well over $8,000 in premium income. Of course my net worth is down almost $12,000 as a result of the decline in the stock price.
I can continue to own the stock, and continue to collect about $3,000 to $4,000 a year in option premiums, or I could sell it now and take my loss of about $4,000 net.
If I believed the annual report, and was convinced that the company earns money on each square foot of sales area it has, and that it is continuing to increase the square footage of sales area so the stock will go up, I would of course continue to hold the stock and continue to collect over 8 percent a year return on its value by writing options against it.
But the fact is that I’ve lost confidence in Walgreens stock, and probably will sell it soon if I don’t see any progress in the stock price. The company does not seem to be able to compete well against its main competitor, CVS, and seems to be tied up in contract disputes.
Even in a “hot” year like we’ve seen so far in 2012, the stock has not done well. And so, as is often the case, when the current options expire on the third Friday of March, I plan to sell the stock and put it into something more attractive.
What might that be?
Lately I’ve been investing more in ETFs than I have in single company stocks. An ETF is an “Exchange-Traded Fund.” That’s about the same as a sector mutual fund, except there are no fees charged, and there are many more sectors available.
For example, if you think that gold is a good investment you can invest in a gold ETF, “GLD.” There is also an ETF for gold mining companies. And there are ETF’s that combine gold with other metals, such as copper, or just precious metals. There are also ETFs that track stocks in particular countries, such as Brazil, or Japan, or larger geographic areas such as Africa. There are ETFs for “emerging countries” and for currencies such as the euro.
In fact, there seems to be ETFs for just about anything you can think of.
The advantage of investing in an ETF instead of a single stock is that it gives you diversification. Most ETFs are funds of a number of different companies. So if one of the companies goes under the overall investment is only slightly impaired, and you don’t lose all of your money.
Some of the ETFs that I currently own are the following:
EWJ — This is the Japan Fund. It holds stocks in large Japanese companies. Many are very familiar names of products I see all the time here in the U.S. and overseas.
EWZ — The Brazil Fund. I bought this when I read in the newspaper about the big oil strike off the coast of Brazil. I think Brazil is a rising star in the world market and their companies will do well.
GDX — Gold mining companies. I bought this as a hedge against a decline in the stock market. I thought that if the market went down, gold might go up.
ITB — This is my most recent acquisition. With the home market way down and construction just starting again, I figured that companies in the homebuilding business would start to show better profits later this year or next year.
IYW — This is the transportation company fund. Someone showed me some statistics that transportation company profits were going up, so I bought this.
PXQ — Computer related companies in the high tech area. Since I don’t hold any stocks in this sector, such as Qualcomm and Cisco, I bought some shares in this fund to round out my portfolio.
I don’t usually write option on ETFs because the premiums are not very great. That is probably because the risk is so much less with an ETF than with the stock of one company. So maybe there is a lesson to be learned there.
For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.