Saturday, February 20, 2010

New Investment in MO

On Thursday I bought 2000 shares of MO at $19.90. I sold (20) Jun 10' $20 calls for .54. There are two dividends before the June expiration of .34 each. Here are the three scenarios that can play out.

Scenario 1: I get exercised before the first dividend in mid March because the call options are ITM. If this happens my return is .54 on the calls and .10 on the stock. Total return of .64/19.90 = 3.2% for 30 days, roughly 38% annualized.

Scenario 2: I get exercised before the June dividend because the call options are ITM. If this happens my return is .54 on the calls, .10 on the stock, and .34 on the March dividend. Total return of .98/19.90 = 4.9% for roughly 120 days, roughly 14.7% annualized.

Scenario 3: The stock trades below $20 near both of the March and June dividends and the contracts eventually expire worthless. In this case my yield off the original investment will be .54 on the calls, .34 x 2 dividends, total yield of 1.22/19.90 = 6.1% for 120 days. If this happens, my risk is that I can't sell another covered call at a strike price above my cost average. But this is the reason I chose a stock I am comfortable owning long-term as the dividend yield is currently 6.8%.

My preference is to get exercised early in March and take the 3.2% for 30 days and move on to the next investment to hopefully replicate the same type of trade in another name. However, I am comfortable grinding away long-term as well as my goal for this portion of my portfolio is to yield a minimum of 1% a month. If I can yield 6% in 4 months then I'm well on my way. Those are small percentages compared to what can be realized on short-term option trades, but the total dollar return and lower risk is what I'm looking for and why I'm classifying it as an investment and not a trade. I'm going to commit $100,000 to these types of investments in hopes of generating a minimum of $1,000 a month from them. I would not put $100,000 in pure option trades that carry 100% risk. So far my average risk on pure options trades is just a few thousand dollars.

Here is a chart in reference to the price/dividend action I spoke of earlier.


  1. So scenario 1 is exactly what I am trying to accomplish with my investment ideas in ANH and PDLI, but am happy to keep them if the puts I sold do not expire worthless (PDLI is a perfect example as I will take delivery of these shares this weekend). So with that being said and with scenario 1 as your preference to the three scenarios you outlined. Did you at least look at what the $20 puts were going for?

  2. I'm assuming you're asking if I looked at the Mar $20 puts? If so, I did not consider selling the $20 Mar puts because if the stock moves lower, you don't get the March dividend as the date of record is between now and March expiration. But we know that selling an ATM put is equivalent to selling an ATM call. The dividend being this month is why the puts are currently more than the $20 calls. Let's just look at a one month example to see.

    Suppose you sell the Mar $20 puts for .45 and it doesn't expire worthless and you're now long at $19.55. Had you bought the stock at today's price of $20.16 and sold the $20 call for .35 and the stock finishes under $20, then you won't be exercised and you get the dividend of .34, this puts cost average at $19.47. So if you were interested in a one-month play, an investor should be indifferent between selling a naked $20 or a $20 covered call. However, if I can sell the June covered call and get that extra time premium, and still get exercised in March, then I've still done a one-month play but gotten more than an alternative of one month's option premium.

    The other reason for going out to June is I'm able to lock in my desired average monthly yield up front, and thereby lowering my reinvestment risk. Example, if you sell the March and then hope to sell the Apr, May, and Jun in successive months, you don't know what the stock is going to be trading at. If it drops to even $19 by Mar OPEX, what is an Apr $20 going to be selling for? Using this month's $21 as a guide, it's bidding at .04, no thanks. So since I viewed this as more of an investment than a trade, I like what I've committed to in the 4-month covered call with two dividends to come.

    And something I didn't mention about Scenario 1, let's say I do get exercised, on paper you would think you would rather have 3.2% for 30 days than 6.8% for 120 days. But this too carries reinvestment risk. What if stocks run up so high than you can't find anything attractive to park your money in, or volatility has come down as stocks move up, now covered call premiums are less as well. While I'd like to have realized gains as early as possible and think I can find another similar investment to make up the difference over the next 90 days, there are no guarantees.

  3. So I was exercised early today on 10 of the 20 contracts, however, I made an adjustment to the trade after my original post. I trade out 10 of the June $20's for March $20. I got .22 for March. I expected to be exercised early as today the stock trades ex-dividend. This means I got a nice return of (.22+.10)/19.90 = 1.6% for only 21 calendar days. This is exactly the kind of quick/safe play I am looking to continue doing with the $100,000 I have set aside for conservative plays that try to yield an average of $1,000 a month. Although I haven't yet committed $100,000, I'm hesitant to get that long right now.

    If the stock continues to stay above the strike of $20, I have to assume I will be exercised early again on the remaining 10 contracts before the June dividend. So I will keep an eye on this as the higher the price goes above strike, the lower the remaining premium will be, and since I don't stand to gain a further dividend as long as the price stays above strike, I will just look to close this out early.

    What is very interesting to me on today's chart is that normally a dividend is priced in slowly over the previous few days or weeks. Today we saw the textbook decline in stock price to almost the exact price of the dividend of .35. Today is the first day the stock trades ex-dividend. I have to say that I've never seen this before.

  4. Today I closed out the second position of 1000 shares. I paid $1.53 to buy back the June $20 calls and sold the stock for $21.42. So I left .11 of time premium ($110) on the table and incurred $10 of trading costs to do so. I just felt like it wasn't worth leaving a $20,000 position on for another seven weeks for a possible $110 of return.

    The total return on this position turned out to be .10 capital gain, .42 on the call, and I got one dividend of .35, total of .87. Cost basis was 19.90. Return is (.87/19.90) = 4.37% for 10 calendar weeks. I'll look to put on a similar trade again if it pulls back to $20.50 or lower.