What do you do when the markets hand you volatility?
One response might be to sell option calls. Selling calls on shares you own (in even lots of 100) can provide additional income or, if you prefer, reduce your risk (your cost basis). Of course, it also involves extra work and extra thinking, but conservative approaches to writing calls can be rewarding as well as risk reducing.
In this article, we’ll look at selling calls on Walt Disney Co. (DIS, Financial), which currently has a place on the Buffett-Munger screener. So far this year it has fluctuated between about $90 and $105; at the close of trading on June 30 it was $97.82.
Please note that this is not a recommendation to trade options or to invest in Disney. Rather it is an educational exercise, using call options and Disney to illustrate opportunities that might arise from combining options with stocks. Unless you have experience with options, you should start by paper trading.
I like Disney for calls for a couple of reasons. First, it has good volume (options volume) and so the Bid/Ask spread stays reasonably tight; big spreads can make it impossible to trade options profitably. Second, it has traded in a range, a wide range it’s true, but a range nevertheless; placing trades on a stock that consistently keeps going up poses additional challenges. Third, the volume also means we can trade in and out of it without waiting for a buyer or seller.
Selling calls on a stock I own is a bit like renting out a house I own. Or to get more technical, leasing a house I own and giving the person who leases an option to buy at a specific price before a specific date. In stock options we have many more choices including expiry dates that may range from a week to a couple of years and multiple strike prices below and above the current stock price.
Here’s just a portion of Disney’s option chain (list of expiries, strikes and prices) for the expiry date of July 8 from Yahoo! Finance:
In the columns above, we concern ourselves with not only the descriptive information on the left side, but also the Bid (price at which we sell), Ask (the price at which we buy), the Volume (number of shares traded today), Open Interest (number of contracts being held but not traded) and Implied Volatility (the market's estimate of how much the stock price will fluctuate in the future).
When we sell an option, we receive our premium immediately but also commit ourselves to selling the underlying stock at the promised (strike) price when the option contract expires. That means you must be prepared to lose the stock if its price rises above the stock price. We won’t cover it in this article, but another type of trade allows us to get back the stock if it is called away.
Call options and objectives
Let’s now look at some possibilities for selling (or writing) calls on Disney. We will write covered calls, which means we will own at least one share of stock for each call option we sell. The alternative is to write naked calls, which means having no stock to cover our calls exposure — unlimited exposure. Selling naked calls can expose one to ruinous costs so few investors or traders use them.
Our objective will be to earn a modest premium, avoid having our stock called away (although we can always buy back in if it is called) and not invest a lot of time (watching the stock and options prices).
I’m finishing this article on June 30 while the market is still open. The following table summarizes five option selling opportunities at this point in the day:
These are just five of literally hundreds of selling opportunities available but will provide some examples.
You’ll see today’s date in the left-most column, followed by the stock price at the time the premium (call selling price) was recorded; three cells have yellow backgrounds to alert you to changes.
The first expiry date is just under one month away and the second is about 6½ months away. The dates have been chosen to illustrate potential choices.
Days Duration shows us how many days until the expiry date and will help us calculate the yields.
Strike Price (green) shows the prices at which the stock would be called away from us; we get paid that amount per share.
Premium (blue) shows the dollars and cents per each option (option contracts always trade in blocks of 100). In this case, the $98 strike price brings in $1.24 per call, or $124 per contract.
The Contract Term Yield is simply the yield between June 30 and the expiry date; it is calculated by dividing the Premium by the current share price.
The Simple Annualized Yield (purple) refers to what the yield would be if prorated to a full year; it is calculated by dividing the Contract Term Yield by the Days Duration and multiplying by 365. I call this Simple because it does not account for changing volatility, supply and demand variations or other factors that might alter options pricing.
Note also that these figures do not include brokerage fees, which tend to figure less prominently when trading multiple contracts. For example, my broker charges $10 plus $1 per contract; more contracts mean a lower cost per contract.
The choices
Let’s look at the table again, this time focusing on the Simple Annualized Yield:
As we can see, the highest return comes in at better than 17%, but it also carries a high likelihood of being called away. While it’s fine to collect the premium and the capital gain from the stock’s higher price, we also concern ourselves with giving away capital gains above $98. For example, if the stock closes at $100 on July 29, then we miss out on $2 per share.
As the strike price goes up, and the probability of having our stock called away goes down, the premium offered also goes down. All of which means that choosing a strike price always means making a trade-off between our desire to collect more premium and our desire to not leave any money on the table.
A tool that can help us understand the dynamics is the iVolatility/TradeKing Probability Calculator.
We put in the stock symbol and the expiry date (Future Date) in which we’re interested and click GO. The screenshot above shows the probability of the stock price being above $100 on Jan. 20, 2017: 39.86%. In other words, if you were to sell $100/January 2017 calls, there is a less than 50/50 chance your shares will be called away. No guarantees, of course, but that’s the probability at this point in time, based on the implied volatility of this option.
Based on the objectives I listed above, I’d likely choose the $105 strike that expires in January 2017. Here's the table again:
At 4.33% annualized it is modest and well below what the nearer strikes offer. At the same time, though, it is the least likely among this group to be called, and it requires little of my time, except to keep an eye on the share price every day or two (daily when earnings come out). Your choice might very well be different, based on different objectives.
Another potential benefit of longer-term options is an opportunity to buy back the calls at a substantial discount between now and expiry. For example, if the stock were to pull back $5 the price of the option would also fall (but not necessarily at the same rate), opening up an opportunity to get out of the contract early while keeping most of the premium.
If I sold calls with the objective of reducing my risk, which assumes a bearish outlook, then I would likely review the potential returns differently. For example, selling the $98/July 29 calls would reduce the cost basis of my stock to $96.46 ($97.70 - $1.24) and my risk by 1.27%.
Conclusion
In this article, we looked at using the sale of call options to add another income stream to a value stock. Disney pays an annual dividend of 1.48%; adding another 4.33% gives us an annual yield of almost 6%.
If we’re holding Disney for the long term and not expecting the share price to grow quickly, then option premiums could pay us while we wait.
Alternatively, if we have concerns about the stock price dropping in the near future, then we might think of the premium as reducing our risk, as it allows us to reduce our cost base.
As noted, covered call selling won’t apply to many value stocks. Unless they have a reasonably high volume of option trades, we won’t want to jump in for fear we might not be able to jump out when we need to.
Options aren’t for everyone. They require additional time and attention as well as a reset on our thinking about company risk.
Nevertheless, they are another tool for our toolbox, and at times will offer careful investors new opportunities to profit.
Disclosure: I do not own any shares or options in Walt Disney Co., nor do I expect to buy or sell any in the foreseeable future.
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