Many stock market gurus have extolled the ability of the stock market to have a greater return on investment than bonds or savings accounts but very few have explained it to the everyday lay-person in a manner that makes sense. While some have advocated a Warren Buffett “buy and hold” where as others have touted the advantages of market timing, one subject that hasn’t been written about extensively for the common investor is the buy-write and covered calls method of increasing the rate of return.
The buy-write and covered call methods are really two names for the same thing. In either case, the investor must own the stock or equity. Another requirement is that the equity must be one for which an options market exists.
So what is an options market? An option, with respect to a “call” is the ability to buy the right to buy a stock at a certain price at some point in the future. An example of this would be Briggs and Stratton (BGG) the maker of small internal combustion engines for lawn mowers and other like applications. If BGG were currently trading at $17.50 and an investor had a belief that in three months it would be worth $21.50, that investor could buy the option to buy the stock at $20.00 in about three months depending on the options available. The investor would likely pay about $20.00 for an option that covered 100 shares of BGG as options are generally available only in 100 share blocks. If BGG then went up to some amount greater than $20, the investor could either exercise the option or, even easier, sell the option as it would now be worth more than $20 and could in fact be worth over $100 if BGG had risen to $21.
With buy-write and covered call method an investor normally buys the equity in 100 share blocks, and then sells the option to buy the equity to the other type of investor described above. In the process described above, the investor buys 100 shares of Briggs and Stratton for $17.50 which means 100 shares cost $1,750. The investor then sells a “call” for three or more months in the future. Three months is the minimum in most cases so that the investor will collect at least one dividend payment before the option would normally be exercised by the investor who bought the “call”. If the investor who bought BGG and then sold the option for $20 still has the stock when the option expires he or she will have collected an $11 dividend and the $20 for the option for a total of $31. If the investor does this each quarter, then after one year the return will be $124 for an annual return of seven percent vice the dividend only annual return of 2.5 percent.
So what happens if the price of BGG goes up to some level above $20 a share? The buyer of the option will likely exercise the option and the original investor will have to settle for a $250 gain on the sale of the stock, the $20 option payment and the $11 dividend for a total of $281 and a 16 percent rate of return.
At this point the smart investor is probably asking what the downside is and what is the risk? The disadvantage to the seller of the covered call is that the upside gain is limited to the price of the option target, in this case, $20 per share. The other risk is that the stock price may decline or that the company may go out of business and the stock would become worthless.
The decision to buy or sell a stock is a personal one. While the equity presented here is available in the option market, this is neither a recommendation for, or against buying the stock. At the time of the writing of this article the author did have a position with an option of the equity discussed.