Fun With Options: Amplifying Returns by Selling Calls
This is the fourth article in my Fun with Options Series:
There are multiple ways to amplify returns.
Today, I will discuss how to Amplify returns by Selling Call Options.
Later, I will discuss how to Amplify returns with Option Spreads.
What’s the Amplification Strategy?
Another way to amplify returns is to sell call options (1 for each 100 shares of stock) for stocks that you already own.
By doing this, you can collect “rent” on your stocks. This is because you are selling someone the privilege to be able to buy your stock at a predetermined price in the future. And that has some value.
When is this Strategy Useful?
It can be useful if you believe the stock will face price resistance in the short term. Ideally, once you sell the Calls, the stock doesn’t move higher, and the Call expires worthless (the best case). This would result in you pocketing 100% of the call premium (i.e. the amount you sold your calls for).
BUT….
A price resistance level is very difficult to predict. If you’re wrong, the stock could appreciate before the call you sell expires, and you would not be able to participate in that price appreciation. That’s the tradeoff.
Recall, by selling your call, you are locking yourself into a price, at which you may be forced to sell at. You wouldn’t lose money if this happens because you already own the stock you would be forced to sell. In fact, you would be guaranteed to make money. However you would lose out on the stock’s upside. That’s the opportunity cost.
I am not a fan of selling such Calls.
Since the market has an upward bias, selling Calls caps your upside. When I buy a stock I expect it to go up over time. So why would I want to cap its upside? I don’t see the point of capping my upside if I am taking on the risk of stock ownership.
As a result, to amplify returns, I’d rather buy calls or use spreads (we will discuss this later).
BUT, Selling Calls Can Indeed Be Useful
They can be useful when you own the stock, and are looking to sell it anyway.
In this case, selling calls would allow you to “squeeze a little extra juice” out of your investment since you were planning to sell anyway.
Let’s assume you owned 100 shares of GM (General Motors) stock (at $33.41 today) and wanted to sell it at $35/share. You could sell one call with a $35 Strike. As of this writing, you can do that for $0.53 (with expiration about 25 days away). Below is what could happen:
Note: You could collect even more premium if you waited until the stock went closer to $35 before selling the calls.
If the stock is higher than $35 at expiration, we make an extra 1.5% than we would have if we had simply sold the stock at $35.
That’s free money.
This is like manufacturing your own “special dividend”!
In the case of GM, this 1.5% is equivalent to about 33% of the company’s current annual dividend. So not bad at all.
If the stock is below $35 at expiration, we are right where we started and could simply sell another call and do this all over again!
Of course, the downside is that the stock falls between now and option expiration. That’s the tradeoff. But, since you already owned the stock, that is not a new risk.
What’s Next?
I will discuss how to use Option Spreads to Amplify Returns.