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Covered Call Analysis Part 1

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By TMFValuemoosie
December 21, 2009

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Hey Fools,

Some thoughts on covered call analysis, tracking, and decision making.

Rule #1 of call writing is to be willing to sell the stock at the strike price.

There are several implications here:

1. Only write calls on stock you feel to be fairly valued.
If the stock is overvalued, it's not a good deal to buy, and if you already own it, you should consider selling it outright. If it's undervalued, then it's probably not a good idea to sell it (at the strike) for less than it's worth.

2. Know the value of your stocks.
What's all this talk of "value"? Isn't the value reported every time I get a quote on Yahoo? Nope. That's the price. While efficient market theory (with emphasis on theory) says price and value are the same, and that all pertinent information is incorporated into the price instantly, Fools know different.

But wait, aren't we talking about options here? Yep, and the key to options investing (not speculating) is to understand the underlying company. Options strategies are just a tool layered on top of your view of the fundamentals vs. the quoted price.

Valuation is a large topic. If you have no clue (yet) how to value a stock, take heart. Some Fools are discussing this very thing over on the Options: Studying Valuation board (http://boards.fool.com/Messages.asp?bid=119545). Also, Jeff and Jim take valuation into account in their recommendations, so you can benefit by just following along.

3. Treat covered calls as a combination strategy.
It's tempting to sell a call on stock you already own, raking in fat premiums while still (hopefully) getting to keep your stock. While this may be the end result, this perspective will cause difficulties. If the stock rises quickly, way past your strike, that premium looks paltry in relation to the gains you're "losing out on" having sold the call.

When deciding to sell the call, look at it as an overall strategy. Buy a fairly valued stock, especially one you think has a "floor" under it, such as a fortress balance sheet, large competitive moat, etc. (So no, setting up a buy-write on that gold ETF probably ain't a good idea). Sell a call, usually slightly out of the money (strike is above the current stock price).

The main thing is to set this up with the mindset that the best thing that can happen is for your stock to be called away. It doesn't matter if, at expiration, the stock is a penny above your strike, or ten dollars. You got your max gain from the strategy.

One other thing. Let's say you already own the stock. How should this affect your decision to sell a call? It shouldn't. Treat every covered call strategy as a logical buy-write. Any earlier gains or losses don't matter. In fact -- options aside -- your initial cost shouldn't factor into your decision to buy more, sell, or hold a stock. Buy, sell, or hold based on your view of the relationship of value to current price. Nothing more. And since options are just a layer on top, the same applies.

A side benefit of this is that it allows us to compare covered call strategies regardless of if we already own the stock or not.

So, you have a short list of fairly valued companies. What's next? How to pick the best company? The best strike? The best expiration?

Let's look at several examples. We'll start with Buffalo Wild Wings, an occasionally volatile stock, and a popular Motley Fool rec that some feel is currently fairly valued.


stock BWLD
stock price 41.16 (a)
expiration 03/19/10
call strike 45.00 (b)
call price 1.75 (c)
net debit aka break even 39.41 (h) [ a - c ]
days to expiration 91 (f)

break even protection 4.3% (g) [ 1 - ( h / a ) ]

Stock unchanged:
PL 1.75 (i) [ a - h ]
% PL 4.4% (j) [ i / h ]
% PL annualized 17.8% [ j * 365 / f ]

Stock above strike
(max gain):
% stock move required 9.3% [ ( b / a ) - 1 ]
PL 5.59 (k) [ b - h ]
% PL 14.2% (m) [ k / h ]
% PL annualized 56.9% [ m * 365 / f ]

A few notes on the calculations:
- Break even (h) is the outlay for the stock, less the premium received for the option. This, not the stock price, is the value-at-risk, and is used for all Profit/Loss (PL) calculations.
- Annualized PL is just a simple normalization to a 365-day period. It's not a compound annual return. The latter is better if you're tracking actual return of a position that is held longer than a year. To extrapolate compounding gains out to a year for something that expires in a few months is misleading at best. Besides, as you'll see, the main use of this number is to compare apples-to-apples against different options having varying expirations, hence the simple normalization (even when comparing longer-term options).

So, here we've chosen a three-month out option, one strike above "fair value", give or take. We own the stock at a net price of $39.41 (h), and we have an obligation attached to the option premium.

The best outcome is that the stock to rises above our strike prior to expiration. We deliver the stock to satisfy the obligation, and we pocket the gain between our cost (aka net debit, aka break even) and the strike price.

The table above shows both dollar and percentage gains. Let's focus on percentages, as it's easier to compare various options, and compare against any internal "hurdle rate" we desire.

So, our max gain for this trade is a whopping 14.2% in three months. Assuming (big assumption) we were able to replicate this same trade three more times a year, this translates to 56.9% per year. Sounds too good to be true.

Well, it may be. This outcome requires that the stock move up 9.3% in three months. Certainly possible, but don't hold your breath. (But that's the beauty of a volatile stock: someone, the person on the other side of the call, thinks it's pretty likely, and are willing to pay up for the chance.)

Let's look at it a different way. Balanced against that lovely upside outcome, what's the downside? Well, the table shows that the stock can fall 4.3% before we lose money. This is because we got paid to buy the stock at the current price. This is reasonable protection for the next three months. The main thing is: how do we feel about the stock at our break even price? As long as it's not overvalued, this is fine. In the unhappy case where the stock plummets in 90 days, we keep our premium (always), but now we own a stock on which our break even price is barely visible way overhead. Well, that's not nice, but remember, barring major fundamental thesis-changing events, if the stock was fairly valued before, it's certainly undervalued now. The likelihood is that it will eventually again approach fair value, and while we're waiting we can sell more calls. The caveat is that if it falls too far, too fast, then the only strikes that pay enough to write will "lock in" a loss. In that case, if you think the stock will bounce up again quickly, wait and write a higher strike after the stock has recovered a bit. But remember, each time you write a call, you lower your original break even price, so you're continually lowering your profit threshold, making it easier to climb out of the hole.

Ok, enough doom and gloom. What if the most likely thing happens and the stock just doesn't move much? Since you sold an out-of-the-money call, it will expire worthless. And you won't have a gain on the stock, but you won't have a loss either. This is shown in the "unchanged" section of the above table.

If the stock does nothing at all over the next three months, we make 4.4%, or 17.8% annually. In a neutral to mildly bullish environment, on a stock that's fairly valued, with a solid "floor", such as a fortress balance sheet, competitive moat, near-term catalyst, etc., this can be a very safe way to earn outsized returns. Before you turn up your nose at 4%, realize you currently get zero percent on cash these days, and the stock market historically has returned around 10% (annually, not over three months). Then look at your own portfolio, and if you've racked up 18% per year, repeatedly, well, chances are you didn't. Especially if the market stayed flat, like we're expecting for our BWLD trade.

One last note on the table. It's easy, using percentages, to add another column and compare the option possibilities of two different companies.

I have more to say on the subject of covered calls, but this post is already long, so look for installment two shortly, where we look at how to pick an expiration month.

Cheers,
-joe
Coverage Fool