Every few weeks, I like to touch on a trading strategy to help you achieve greater returns. In this column, I’m going to talk about using a simple option strategy that could increase your profits.
In spite of all the gloom and doom, the bubble-like housing market continues to be red-hot in many parts of the United States. The number of building permits has exceeded two billion for the last nine consecutive months and 12 of the last 15 months. At the same time, the number of housing starts has been above two billion in seven of the last 10 months. Low interest rates continue to drive the buying, but speculation is also rising as the desire for profits drives the action. The reality is, as interest rates continue to rise as I expect, we will see a burst in the housing market.
We recently saw some weakness surface in the homebuilders on concerns that rising interest rates may choke the housing market. Key players such as Hovnanian Enterprises (NYSE/HOV), Toll Brothers (NYSE/TOL), Lennar (NYSE/LEN), Pulte (NYSE/PHM), and KB Home (NYSE/KBH) were all roughed up.
So if you are long in housing stocks, what should you do? Do you sell now and risk more potential upside gains? Or do you hold the stock and hope the bottom doesn’t drop out?
You can initiate stop-losses on your stocks, which is always the safest way of protecting yourself and something I really advise, especially in sectors that may be showing a potential top. But how about a strategy that works when the stock goes in either direction?
Are you familiar with covered call writing (also called Buy- Write)? Covered call writing is straightforward, low-risk, a generator of premium income, and as well as a guarantee of a selling price for the stock. But don’t write a covered call if you don’t want to lose the stock due to a possible exercise from the call holder should the stock rise above the exercise price.
In my example, I will use Toll Brothers, trading currently at $50.09 per share. Let’s say you own 1,000 shares at a cost base of $40 per share. You believe the stock has further upside, but, at the same time, you are also concerned that the stock could be set for a fall.
Let’s say you are mid-term neutral on Toll and believe the stock might have limited upside potential prior to March 2006. Given this, you could generate some premium income by writing calls on your 1,000 shares of Toll. By writing the calls, you, in turn, are required to deliver your 1,000 shares of Toll at the predetermined strike price if exercised and only if assigned to you.
Here’s the mechanics: You own 1,000 shares of Toll and decide to write 10 Toll March 2006 $60 Call option contracts at $300 per contract or $3,000 for the 10 contracts. This is the risk premium you get for assuming the risk and is yours to keep whether the call options are exercised or not.
The strike price selected in call writing should be what you should feel comfortable selling the stock at, if it were to be exercised. If the strike price is set too low, it would have a higher probability of being exercised and you could lose your shares, perhaps at a lower price than you would want. Conversely, setting a lower strike price translates into higher premiums for you. The decision ultimately depends on your view of the market.
Now assume the share price of Toll fails to reach the $60 strike price by the March 17, 2006 expiry. In this case, the call option would simply expire, and you want retain the $3,000 premium (excluding commissions). The end result would be a decline in your average cost base of Toll to $37 a share. You can then write more covered calls to generate additional premium income.
Conversely, say Toll surges to $62 a share by the March 2006 expiry. In this case, you would be obligated to sell your 1,000 shares of Toll at the $60 strike price. But that is not bad. You make another $10 a share in gains plus the $3 a share in premium income for a total gain of $13.
Now what if Toll declines to $45? You would be down only $2 a share, as $3 is offset by the premium income you received for writing the Call. At this point, you can decide whether to sell.
If you are interested in this strategy, I advise you to paper trade first to get use to the mechanics and see how covered call writing can benefit you.