At the beginning of each year I pick eight to 10 stocks that I plan to focus on for the coming year. I look for stocks that will have low volatility but are likely to go up a little bit in value (maybe 3 to 6 percent) and not decline. Then I write covered calls or spreads on those stocks during the year. Or sometimes naked puts.
While I may have made money on them, this year my picks were nothing like I expected.
Let‚Äôs start with Bank of America. When it was $5 it looked to me like a stock not likely to go down, but with all the problems banks were having, especially that bank, I did not expect much volatility ‚Äî especially on the up side. So I invested $700 in 10 January 2013 puts to protect against a downslide and reduce my margin requirements, and began to sell at-the-money puts each month. For five out of six months I made a small profit while the stock went from $5 to $10.¬† But that is not what I call a “non-volatile stock!” I made about $1,700 profit. Some option writers would say that they more than doubled their money on this group of trades, investing $700 and profiting at $1,700.¬† I don‚Äôt look at it that way.
When I look at profits from option writing I take the risk as my investment. So when I first sold 10 puts with a strike price of $6, I was at risk of having to come up with $5,000, less a few hundred dollars of premium income, if I was to put the 1,000 shares of stock at $6 per share. So I look at my investment as $6,000. Not that a 28 percent return during six months is bad.
But I compare that to what would have happened if I had just bought the stock. In that case I would have doubled my investment.¬† So in this case buying would have been better than option writing ‚Äî if I sold now, when the stock is over $10 a share.
Now look at Whirlpool. When it was around $55 a share it looked like a great deal. The stock had not performed all that well, and with the Chinese economy going down, but the U.S. housing market starting up a little bit, it looked like a solid stock to own. It paid over 3 percent in dividend yield, which gave it downside protection, and had the increasing housing market to give it a potential slow upside.
But it didn‚Äôt happen that way. Instead the stock jumped by leaps and bounds and is now around $100 a share. I wrote calls over and over, just keeping my head above water, while the underlying stock that I bought went up in value. Finally I let the stock be called away at $85 a share. So I left some money on the table. Again, while I made a nice profit, buying and holding would have been better.
And what about Green Mountain Coffee Roaster? When it dropped from over $100 a share to about $22 I figured it had hit bottom and it was time to buy in.¬† Being a bit short of cash at the time I sold the 20 puts and took in a nice premium. I figured that the stock had leveled out and would hover in the low 20s for some time. Wrong again. It went down to $17, but then came back up into the 20s then, more recently, jumped up in several spurts until it is now about $38. I don‚Äôt know what happened to my expectation of low volatility.¬† I‚Äôm lucky to have made even a small profit with that much volatility. I got to keep the $1,000 premium on the sale of the 20 puts, but I didn‚Äôt benefit from the jump from 20 to 38.
I did pick a few more appropriate stocks for option writing, and made a bit of profit on them, but let‚Äôs look at the one that has not turned out so well thus far: Apple.
Looking back at it, Apple was not a good selection for an option writer.¬† I don‚Äôt consider it a non-volatile stock. But based on research by a friend, I became convinced that it was on an upward move toward at least $800 a share. With the stock at over $400 a share it was too expensive for me to take a big position in the stock, so I bought a few hundred shares, and wrote put spreads. I was about $25,000 ahead at the peak.
This worked out well until recently. Then suddenly the stock took a big dive and I lost back all of the profits. To hedge against a continuing decline, I wrote a call spread. The stock jumped up and I lost money on the call spread. So I wrote another put spread. The stock tanked again and I lost money on the new put spread. So I wrote another call spread. Through it all I held on to five naked puts at $580.
So there went a lot of my profits for the year, depending on what happens in the next 30 days. If, lord willing, Apple stock goes up over 575 but not over 600 I will end up with a small profit on the Apple positions overall. Otherwise I will lose somewhere up to $25,000, wiping out almost all of my option writing profits for the year.
It was not a good year for an option writer like me.¬† But I had a lot of fun!
Now I start looking at stocks for the New Year. Will Apple come back? Will RIM in fact go out of business? Will the housing ETF‚Äôs continue to go up as housing comes back? Will gold decline as the economy stabilizes? Is there really a copper shortage in China‚Äôs manufacturing sector? Will the European market continue its downslide, resulting in fewer exports for U.S. products? Will Brazil be able to begin to profit from their offshore oil?
So far I‚Äôm holding on to FRX and GDX, as a commodity play. As the economy improves one would think commodities will go up. I continue to hold WAG and write covered calls on it, thinking that some day the customers will come back, after the disastrous contract boo-boo by management. And perhaps the new health care regulations will encourage more people to go to a doctor and get prescriptions for pills. But until January I‚Äôm selling out a lot of ETF and fund positions and holding cash. With the political area as it is right now there is too much risk of volatility in the marketplace.
After the politicians decide on next year‚Äôs tax structure I will go back into the market. A rise in the capital gain tax, or the elimination of the tax deduction for home mortgages could push the market sharply down for some period of time.
There is no doubt in my mind that in 2013 we will have even more fun than we had in 2012. But I don‚Äôt guarantee any profits.
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.