NEW YORK ( TheStreet) -- Roughly half of the articles I write deal with options. I also publish a weekly
Options Investing Newsletter that targets relatively conservative long-term, growth and income investors, who like to speculate with a small portion of their portfolio. Much of my work focuses on debunking myths and misnomers about options. Many investors never even consider using options because of the hysterical misinformation that abounds. They instantly consider options too risky, associating an options trade with little more than gambling. I have a theory as to why this is so.
With few exceptions, most basic options information flat out stinks. There comes a point where you can provide a novice with too much information. It's tough enough to wrap your head around the basic functions of calls and puts the first time you encounter them, let alone understand the nuances of implied volatility and the Greeks. I am not saying these things do not matter or that people who use options should not learn them; however, to get started using options in the most basic fashion, you do not need to get bogged down in complexity. In addition to information overload and the confusion it triggers, humans have a tendency to do too much too soon. We also desire instant gratification. If you're bullish Intel ( INTC), for example, you might be the type of person to psyche yourself up about buying deep out-of-the-money calls because you think the company will blow the doors off of the next quarter. Sirius XM ( SIRI) is really the best case in point, as are other sub-$5 stocks. Scan the message boards on SIRI. You will see countless bulls scoreboarding about how many $2.50 and $3.00 calls they own. The same phenomenon ran rampant when Citi ( C) was flirting just shy of the $5 marker pre-split. We often want to go for what we perceive as the big score. And if an OTM call costs so little, we ignore the reasons why it is so "cheap" to focus on the massive percentage returns we can realize if the underlying stock hits our obscene and baseless price targets.
Before you know it, things like implied volatility and time decay have an impact and your once "cheap" OTM call is now worthless. You have no idea what hit you. That's because you (A) received bad or far-too-ambitious information and (B) you had no business being in a trade -- fueled by emotion -- that you did not understand. The result, you rationalize what happened and make more bad trades, or you cast off options all together and move on. It should not, and doesn't have to, be that way. If you get into the proper trades in the first place, things stand a much better chance of going well for you. For beginners and beyond, the best options trade is the one with the fewest things to have to think about. Let's consider INTC first. I do not have a large position in the stock. I just bought it and plan to scale into a position over the course of the year. I only have enough shares to write one covered call against. You might think that I should just move on from the idea of using options in conjunction with 100 shares of my INTC position. As the screenshot from my account shows, I am in the beginning stages of my covered call strategy and INTC position.
I collected 22 cents in early April on an INTC April $29 call that ended up expiring worthless. Today, I sold an INTC May $28 call and took in 25 cents. Before commissions, that's 47 cents, or $47 worth of income. After the relatively steep commissions I pay at this brokerage, I "only" generated $29.60. (As an aside, I have several brokerage accounts. This one has the highest options trade commissions. I take that hit because it's much less expensive to scale into a position in relatively small increments in this account than it is in my others. This works for me). Assuming my shares never get called away, I plan to sell an INTC call a minimum of five more times this year. If I net $14.80 each time, I take in $103.60 worth of covered call income on 100 shares of INTC that the person who never wrote the covered calls left on the table. Sure, I share that income with my brokerage, but I have essentially set up a situation where Intel pays me -- indirectly -- another dividend.
INTC yields 3% on a dividend per share of $0.84. On 100 shares, you'll make $84 annually in dividend income. So, what seems like small potatoes -- $103.60 in covered call income -- actually amounts to more than I make in dividend income. Let's not forget that along the way, I will be doing two things: Buying more shares on a regular basis and reinvesting both my dividend and covered call income into more shares of INTC. Before you know it, I will own 200 shares of INTC and write two covered calls each time and collect double the dividend; and so on and so forth. In 10 or 20 years, you really begin to see the power of this approach. Impatience trips up most investors. The early days of building a position and income reinvestment are the dog days. We see those "small" numbers and lose our resolve, opting instead to take flyers on other small numbers ("cheap" deep OTM calls) that have an incredibly low probability of paying off. While that sort of speculation might not nip the INTC investor that much, it nails the penny stock crowd that pumps stocks like SIRI. If you buy a SIRI $3.00 call, you are on the wrong side of the trade. No question about it. Sure, instances will occur where you will hit a home run on this type of low-probability trade, but, more often than not, you made a sucker bet. Instead of complimenting your 5,000 shares of SIRI with a lotto ticket, sell those $3.00 calls against the position. Or, better yet, notch the strike down to $2.50. You could sell 50 SIRI June 2012 $2.50 calls and collect $0.05 apiece for a total of $250, as of this writing. Even if you pay $50 in transaction costs, you still net $200. Do that three times a year and a stock that does not pay a dividend generates about $600 in income. You would need about 750 shares of INTC to trigger enough dividend income to match that. If you plan on being long for the long haul, the primary "risk" associated with writing covered calls is losing your shares. If the underlying stock moves above the strike price of the call you sold between now and expiration, you could have your shares called away. You will almost certainly get assigned if the call is in-the-money at expiration.
As long as you select a strike to sell, that caps your gain at an acceptable level, I do not consider this a risk. I consider it an income generation method most investors probably miss out on for no good reason. In an article later this week or next on TheStreet, I will outline what you can do if you fear getting your shares called away, or if that ends up happening.