A Few Thousand Dollars I'll Gladly Give Up

If nothing changes, over the next couple of months, I'll be leaving nearly $3,000 on the table in order to sell shares of stock. And that's money I'll gladly part with, because it's money I never should have seen in the first place.

That cash represents the incremental gains I would have potentially been able to pocket had I sold the shares at their recent market price, instead of writing covered call options and agreeing to sell lower. It's the risk that comes as part and parcel of the strategy of selling options, but it's a risk I'm happy to take because of the significantly improved selling discipline that comes with it.

What have I gotten into this time?
By selling the options, I've sold someone else the right to buy my shares at a specific strike price at or before the options expiration date. I pocketed a bit of money on the options sale, but because the shares now trade above that strike price, I risk having the shares called away from me. The buyer of those options would then pocket the difference between the strike price and the market price of those shares.

The table below explains the situation:

Source: Author's brokerage account.

This, of course, raises two key questions:

• Why did I sell the options?
• Why am I happy to leave money on the table?

Both questions can be answered with one word: valuation. As a shareholder of both Select Comfort and Discover Financial, I estimated a fair value to their shares that was greater than my original purchase price but less than the strike price. In Select Comfort's case, I think those $28 shares ought to really fetch closer to $20, and in Discover's case, those $30 stubs ought to be in the neighborhood of $25.

I bought them significantly below those levels -- paying a weighted average of $13.69 for each Select Comfort share and $13.22 a stub for each Discover one, before commissions.

For Select Comfort, I admire the brand and the innovation, and its position as a relatively small player gave it room to grow in an otherwise mature and cyclical bedroom market. I had owned some before the crash but bought significantly more as soon as it became clear that the company would survive. Still, no matter how admired, no company can perpetually grow faster than its industry, which is what put that $20 ceiling on my view of its valuation.

When it comes to Discover, the market threw a clear fire sale amid the financial meltdown that let me buy its shares dirt cheap. All I had to do was have faith that the company would survive the panic -- which, given its very healthy balance sheet, I was confident it would. Low interest rates, an improving default picture, and a recovering economy provided the impetus for the company's stock to recover to a much more reasonable level -- and now to one that has reached into my sell territory.

Now that they've surpassed what I think they're truly worth, I need to be willing to part with those shares and redeploy the capital into the next opportunity. That's where the covered call option sales come in handy.

The certain cash versus the potential upside
Prior to embracing the strategy of selling covered calls to enforce selling discipline, I had a terrible habit of letting my winning picks run -- until they collapsed. I've lost count of the number of times I've kicked myself for not selling when I knew I should have, only to wind up holding shares priced well below what they had been previously fetching.

Perhaps the most egregious of those cases involved mortgage REIT Impac Mortgage Holdings (AMEX: IMH). Prior to the real estate bubble collapse, I owned 975 shares of that stock, which I valued at $10 a share. I pegged the stock at that level based on the fact that it generally took first position mortgages and required decent down payments for its ALT-A paper. What I missed in my valuation -- which turned out to be too high -- was the possibility that even 20% equity could be evaporated in a meltdown.

The market generously served me up a price as high as $11.74, but I stubbornly held on -- hoping for $12. Well, that bubble burst, and those 975 shares are now 98 after a 1-for-10 reverse split. To add insult to injury, each of those reverse-split shares recently commanded a whopping $2.79 in the market.

In essence, I threw away more than $11,000 because I got greedy for an extra $250 that never arrived. With that as a backdrop, it starts to get a lot clearer as to why I'm gladly leaving that nearly $3,000 on the table for actually getting around to selling Select Comfort and Discover. Because while I may be sacrificing that incremental upside, if all the shares are called away from me, I'll still be pocketing in the neighborhood of $20,600, plus the premiums I received for selling the calls.

I'd much rather have the cash and the gains than an unfilled limit order at a hoped-for price that never materializes along with a bunch of stock priced at substantially less than it had previously been trading at. The premiums I got for selling the call options are what enforce the selling discipline needed to make sure I sell when I should. Having been burned with far too many wipeouts, I feel that the incremental cash I may be leaving on the table in this case is a small price to pay for the benefits of walking away largely intact.

Do what it takes to invest well
If my All-Star rating at Motley Fool CAPS is any indication of what my portfolio could look like if I consistently invested based on my own convictions, it's a clear signal that I need to put my money where my mouth is. That's why not only have I written those covered calls to sell the shares, but I've also red-thumbed both Discover Financial and Select Comfort as underperform CAPScalls.

I like both companies enough to have been a shareholder, but not so much as to hold on at any price.