Long-Term Covered Calls
The Smart Profits Report: Issue #169
Tuesday, December 21, 2004
Long-Term Covered Calls: The Best Way to Play Sirius Satellite Radio
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
A month ago I recommended buying shares of Sirius Satellite (Nasdaq: SIRI). At the time, Sirius shares were trading far below the current prices.
I gave subscribers to the my trading service very specific reasons to buy the company now. And I included a long-term covered call play that I think is the smartest way to play Sirius.
If you don’t know what a covered call is, here’s a quick take that will help you understand the Sirius play I’m about to describe… A covered call combines two instruments: an option and a stock.
Long-Term Covered Calls Just Make Sense
It works like this: You buy shares of a company like Coca Cola at, let’s say, $50. You think Coke will go no higher than $55 in the next 12 months. If it goes higher, you will sell since that is your target price.
So far, that’s just normal investing. Well, if you can handle that, then why not make MORE money than just the $5 that you projected to make?
To do this you would SELL (or write) a $55 call option against your Coke position. You can sell one option for every 100 shares of stock you own. When you sell your call, you will be obligated to deliver the shares if requested. That may or may not happen. Nonetheless, you will be sure to receive something for the option you sold. It’s called a premium. And it can amount to a good deal of money.
One way to view this premium is as rental income on your stock. You get the “rent” the minute you sell the option.
The transaction you entered - when you sold your call and collected your premium - has one consequence you have to find acceptable. It limits your upside gain on the stock (in the Coke example, to $55), since that is the strike price at which you’re obligated to sell your shares.
Looking for Reasons NOT to Buy
What we do with the Income Trader is trade covered calls using a system and a set of criteria…
We’ll take a company that we like, such as Sirius. And the first question I ask is whether Sirius is a company I want to add to my portfolio regardless of the circumstances. (Well, almost… To me the most extreme circumstance is when the management of the company lies, or another competitor is going to put my company out of business. And these are deal breakers.)
Then I look at the fundamentals…
- Can the company survive through thick or thin?
- Does it have enough cash?
- Are the insiders unloading or loading?
- Is the business competitive?
Basically I am looking for reasons NOT to buy a company. When I am satisfied with the fundamentals, I look to the options market.
I am looking for a specific return. I want to make at least 1% to 2% per month from my picks. AND, I want to buy the shares at a whopping discount to the current price, if possible.
Simply put, I want to buy the shares at my price, or I want to be paid at least 1-2% per month for trying.
And I got Sirius at my price… in fact, we’re holding it right now…
Our trade worked out like this. We have the following possible outcome:
Either we will make close to 20% on the position in a year, or we will own Sirius for $2.10 per share. At the time our downside cushion on Sirius was about 35%. This meant that Sirius would have to fall more than 35% from the price that we paid, in order for us to lose any money.
A Downside Cushion of More Than 70%
As it stands today - only a month later - Sirius is at $7.50. This means that Sirius must fall more than $5.40 per share for us not to win on this trade. That is a downside cushion of more than 70%! Here’s the great part: Many of my readers have already made close to 20% on this trade in one month. That’s right: They did not have to wait another 12 months.
Why? That’s today’s lesson.
When you sell the right to someone to buy your shares, as you do when you are writing a covered call, the person who buys the call can exercise the option to buy your shares AT ANY time as long as they pay your strike price.
In this case, the option buyer exercised his option - for whatever reason - 12 months early. That resulted in a gain of almost 20% in one month as opposed to 12 months. That is a good trade in my book. And it is not the first time this has happened.
A couple of years ago we covered our positions on Intel, Cisco, Motorola and Oracle for average returns of 15% to 20%, more than six months prior to expiration. If we held the positions to term, we would have made 1% to 3% more. In this case, the extra six months of risk was not worth the extra gain.
So we booked our profits and got out… always a great option to have.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Check out our Smart Profits Glossary if you are having trouble defining option terms like “covered calls” or “strike price”, it’s chock full of over 150 option terms!
- For more on covered calls, swing over to Smart Profits #180, Deep-In-The-Money Covered Calls, also by Karim.
Related Articles:
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Strike Prices:Increase Your Odds by 99%
- Options Leverage: How to Use Delta to Maximize Leverage
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