Another strategy that can be used by investors is one that has a high probability of success and a low probability of loss. This strategy is to provide consistent returns and is not speculative by any means and will not produce outsized returns. The premise of the investment strategy is to hold long 100 shares of stock of a particular security and selling a deep in the money call option in the hopes of being assigned. The investor will weigh risk/return on a particular stock and this strategy should be used in a diversified manor to provide more consistency to weigh out any outlier security that does not perform as to expectations.
To get a better idea of how this strategy works, we will apply it to Advanced Micro Devices (AMD), which has recently been under pressure from its larger rival Intel. It is currently trading at $15.69 a share and we will be looking at going long 100 shares of stock. Which would give us a total cost of $1,569. Because we like the company and feel the future is promising for the company we are comfortable with the position that was initiated, however, we still aren’t 100% comfortable that they will be able to act on their future plans. We will then sell 1 call option against that position, but instead of selling one at a higher price, we will sell one that is far in the money. We identify the January 2008 $10 call option currently trading at $6.60. By selling the call option we will receive $660 from the premium, thus lowering our initial position cost to $909. We are protected from any losses down to $9.09 per share. This is how the trade would look at different price levels in January 2008:
$0.00 - -$909
$2.50 (-84.00%) - -$659
$5.00 (-68.13%) -$409
$7.50 (-52.20%) -$159
$10.00 (-33.27%) +$91
$20.00 (+27.47) +$91
While it might seem that you are making a risky bet on the stock by risking $909 to make $91, if has, in fact, a high probability of being a profitable trade. That $91 represents a 10% return should the stock be trading above $10 one year from now in January 2008. This means that the stock can drop 33% from its current level and you will still profit.
This strategy can, at times, generate negative returns especially in declining markets and company fundamentals, so this strategy would require some analysis to be done by the investor. This strategy can also be combined with dividend paying stocks, which in this strategy will provide some additional returns and will lower the cost basis of the trade. The effects of purchasing your shares on margin and selling call options against those shares will be analyzed in an upcoming post.
The effects of taxes and commission was not taken into account in this example.
