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I am new to options trading (<1 month). I recently sold a rental unit and I have been slowly allocating the cash into stocks. I want to utilize options and I need some help to make sure I am not doing something stupid.

I will buy 400 shares of VPU $123.49 for a total of $49,396. I want to sell a December long call with a $125 strike price which will yield about $920 (I checked this in RH today). In the next 6 months I will receive about $1250 of dividends. Assuming that the stock will be higher than $125 in December, I will get:

400*(125-123.49) = $604

The total of this transaction will be:

$920+$1250+$604 = $1,824

... or a 5.55% return in 6 months (11.1% per year provided I can do the same in 6 months).

I think that utilities are stable and the dividend helps boost profits. This analysis sounds too good to be true so I want confirmation that I am not missing something. Any thoughts?

Is there any way to quantify or calculate a risk number based on this (or any other) option strategies? Is there a better way (more profitable/less risk/less money needed) of accomplishing this? I appreciate your answers!

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First, a small correction in terminology. In a covered call you sell a short call not a long call.

Dividends do not boost profits because the stock exchanges reduce share price by the amount of the dividend on the ex-dividend date. You could go so far as to suggest that a dividend 'boosts' the potential profit of the covered call but in truth, proper accounting is responsible for that.

As written, your math does not add up because you have only included the premium received for selling one covered call. Using the numbers you provided, the math for assignment would be:

-$49.396 cost of 400 shares

+$3,680 premium from 4 short Dec $125 calls @ $920 ea.

+$1,250 dividends received

+$50,000 sale of 5400 shares


+$5,534 potential gain

Your dividend assumptions have some issues. VPU went ex-dividend 2 days ago for $1.2578 per share. 400 shares times two dividends would amount to $1,006.24 so if you expect to collect $1,250 in dividends in 6 months, that means that you expect a 20% boost in dividends. That's optimistic, especially in this market environment.

The second issue is that in the past 10 years, the ex-dividend dates for VPU have been from 12/12 to 12/22. December expiration is 12/18 so it's possible that you won't receive the second dividend.

There is a second reason that you might not get the December dividend. If VPU's price rises sharply and your short call becomes deep in-the-money then your position may be assigned before the December ex-dividend date. This is a frequent occurrence when there's a large dividend. This would be a good thing if it occurred soon because it would increase your ROI but a bad thing if it occurred just before the December ex-div date.

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I want to sell a long call @ $125 strike price (Until December) which will yield about $920 (I checked this in RH today)

The bid-ask midpoint of the call is $9.20, but the spread appears very wide, so you may get less than that. However, you seem to be counting only 1 contract, whereas you would sell 4 contracts against 400 shares, right? So you would get considerably more than $920 in premium.

$920+$1250+$604 = $1,824

As written this does not add up.

I am thinking that Utilities are more or less stable

If you think this (you expect more stability than the market expects), then selling options makes sense. However, the option premium in the market reflects a fair compensation for the expected volatility of the ETF as estimated by professional traders. Thus, to the extent you gain a juicy call premium, you can expect a substantial risk that the ETF declines enough to cancel the gain.

the dividend helps boost profits

Dividends do not create total return, because they come out of the value of the ETF (its price/NAV drops on ex-dividend day). Dividends may be a reflection of stability. But today's pricing of the ETF already reflects future dividends (since everyone knows about them), so the dividends in no way assure a positive return from here.

I want confirmation that I am not missing something

Another thing to keep in mind is assignment risk. If the ETF rises substantially above $125 and the calls have little time value, then they are likely to be exercised early, before a dividend. In this case, you would miss out on the remaining dividends.

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  • you are right, more in my favor, 4($920)+$1250+$604 = $5,534! that is about 20% per year! – lgalico Jun 25 at 14:19
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When looking at the risk of a portfolio it is important to look at both up and down side risk.

As other's have mentioned, your calculations regarding the option sale proceeds are a bit low. The thing I would like to add to this is that currently the bid-offer spread of call options at strike price (K) = $125 is $5.10 - $13.30 (VPU options). This means if you wanted to sell these options right now, you could only get $5.10 per option. I would also add that there has been 0 options traded at this strike price, this adds to the uncertainty of the option price you may be able to trade at.

Others have also mentioned the risks around the dividend return both being lower than historically due to the current economic (and therefore market) conditions and not being received due to transaction timings. As utilities provide a necessity, they're more likely to have a consistent cashflow, this reduces the risk of a reduction in dividend but doesn't remove it. The ETF wasn't providing dividends before 2013 (as far as I can see), so it is difficult to know how the fund would react in a recession with regards to providing dividends. In terms of risk to your overall 'portfolio', this is a relatively small element of it. There is much more variability in the underlying share price and therefore option value.

Looking at the risk to your portfolio as a whole (shares + options), I find it helps to look at a chart of the potential return vs. the share price at option expiry. If we firstly look the payoff for each component (shares, options & dividends) we see that above a closing share price of $125 the payoff is fixed. This is what the call option does when you sell one. Below, the share return is perfectly correlated with the share price as the options will not be exercised.

Payoff by portfolio element vs. closing share price

And looking at the annualised return of the portfolio vs. the annualised return of the shares, we see a similar story.

Annualised return of portfolio vs. annualised return of shares

(For these calculations I have assumed the dividend per share of $1.26 is repeated in December)

Regarding the likelihood of the outcomes, the closing share price range I have used is the 52 week range i.e. the share price has been at every point on the x-axis in the last year.

Assuming dividend income is received, your break-even expiry share price is between $117 - $118.

The predominant driver of share options is the volatility of the underlying share, where, if the options is out of the money, more volatility will increase the value of standard call or put options as it becomes more likely for the underlying share price to finish in the money. Vice versa if the option is in the money. There are a number of different metrics to quantify risk (variance, sharpe ratio, Value at Risk (VaR), Tail Value at Risk (TVaR)) but they all centre around variance at the core.

Edit: I missed the fact that dividends have historically (since 2013) been paid quarterly, so my calculations are ~$600 too low at every point on the curves as I assumed half-yearly dividends.

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  • Thank you Will, I appreciate the thorough explanation and the graphs. One comment; I have owned shares of VPU for ten years, it has always paid more than 4% dividend. I disagree with all these comments that state that the dividends are not guaranteed. 10 years of dividends tell me that they are almost certain. I have experienced dividend cuts in the past (GE, MFA) but I feel the risk of a dividend cut in utilities is minimal, specially in an ETF. – lgalico Jun 25 at 14:38
  • You're welcome! I agree that Utilities dividends are more likely to be consistent relative to other industries due to providing a necessity and therefore are more likely to have a consistent cashflow. Re-reading it does sounds like I have the view that dividends are more than likely not going to be received. What I was trying to highlight was that in the current economy (raised unemployment, potential recession) it is more likely that profits are lower in the short term and therefore a higher likelihood of a lower dividend. I included 0 dividends a worse case scenario in that respect. – Will Blair Jun 25 at 15:15
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A six month time period whereby the amount of income and capital-gain is logically planned ?

The position is exposed to loss on the downside of the underlying. The underlying could be hedged by selling three micro-S&P 500 futures but then loss on the hedge is a problem on the upside of the hedge. But the hedge is liquid and available almost 23 hours a day so the hedge could have stop-loss orders on it.

Making the trade publicly known increases demand for the underlying but increases supply of the option

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  • 1
    And you think that a futures hedge is an appropriate recommendation for someone new to options who is trying to figure out the math of a basic covered call? – Bob Baerker Jun 25 at 0:01
  • I think it is very wise to consider the possibility of the downside of a six-month strategic position and where the position is not a long-term holding but allowed to be called away. – S Spring Jun 25 at 0:10
  • With investment advisers, an important standard for brokers is Know Your Client. In a similar fashion, your suggestion to utilize futures lacks that insight since it well beyond the awareness of an option beginner. – Bob Baerker Jun 25 at 0:50
  • The OP demonstrated investment knowledge and interest in investment endeavor. I think the OP was asking for additional viewpoint. A possible downside greater than the option premium received is a fundamental to consider. – S Spring Jun 25 at 2:02
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You haven't actually run the numbers to determine whether or not this trade is a winning plan. You seem to think that maybe you have, but you haven't.

Keep in mind that covered calls can be deceptive. At first glance, they seem like a win-win strategy. If the underlying goes down or stays the same, then the option premium is extra money in your pocket. If the underlying goes up, you end up with a profit. You're happy either way, right?

Wrong.

It's important to look at the downside, too. If the underlying goes down below the breakeven point, you've outright lost money. Conversely, if the underlying rises above the strike price, then that option immediately starts taking away any further gains from the rising stock price. Now the win-win is starting to look more like a lose-lose.

So what should you do? You need to analyze both of those risks, weigh them against the benefits of your strategy, and see whether or not the benefits are greater than the risks.

How can you do that, exactly? Well, I don't have any good advice for you. The most sure-fire way to learn how to price options is, perhaps, to get a degree in quantitative finance.

By the way, keep in mind that the people setting the prices of options do have degrees in quantitative finance. They know far better than you what a fair price for any option is, and they're unlikely to want to buy it from you for a fair price.

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  • No one ever loses money on a covered call. It's the underlying that kills you :->). Covered calls have an asymmetric risk profile - small potential profit wile bearing all of the downside risk. For that reason, AFAIC, spreads are a better choice because they shift the R/R of the strategy closer to balanced. It's a bit contradictory but I'd say that covered calls are best suited for someone willing to hold the underlying who has a target sale price. Collect premium until target reached. – Bob Baerker Jun 25 at 11:42
  • Thanks for your answers. I assure you Tanner that fancy degrees are nothing but a piece of paper. I am en Engineer and am amazed how; to this day, haven't met a single mortgage officer who can deduct the mortgage payments formula. It is as if the formula was magically created. Since I know how to get the formula I don't have any respect for these "experts" (sorry if I offend anyone). I buy and hold ETFS; If the price goes down I just wont sell and write another call upon expiration. If value rises above strike then I buy more shares with margin. Looks to me like a win-win situation – lgalico Jun 25 at 14:11
  • @lgalico - I'm not going to attempt to dissuade you from the covered call strategy. If you're comfortable with it then it's right for you. However, its R/R isn't particularly attractive and if the underlying drops significantly, you won't have the opportunity to write more covered calls without locking in a loss (see 2008 when the SPDR Utility ETF dropped nearly 30%). And while utility dividends seem like they're secure, that's not always the case (see 2007 when many utility stocks cut their dividends). – Bob Baerker Jun 25 at 17:05
  • Bob: What do you think the right strategy is? I don't need to incorporate options in my retirement funding journey but looks to me that using them will help me retire much earlier. Any advice of what to do to boost profits for low to medium risk portfolios? Buy and hold has worked for me but I want to see if I could do better adding a little bit more risk. – lgalico Jun 25 at 17:22
  • @lgalico It's great to be skeptical of others! But you have to be skeptical of yourself, too. Let me re-emphasize that you haven't run the numbers. If the actual volatility of the stock is greater than the implied volatility of the option, then writing the option is a losing bet. How does your analysis mesh with that fact? Given that writing covered calls is a good idea in some circumstances and a bad idea in other circumstances, how did you determine that these circumstances are the former and not the latter? What have you done to rid yourself of gambler's fallacies? – Tanner Swett Jun 25 at 21:05

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