Stock Options: How to Squeeze More Money Out of a Share Price

Colorful of Australian Currency on white plate on wood table
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Whether you’re a short term trader or long term investor, knowing when to exit a position is one of the toughest things to get right.

Who hasn’t gotten out of a stock only to watch its share price steam higher? Yep, it can really make you wince — and provide plenty of material for a (not so) healthy dose of ‘self-appraisement’.

It’s easy to second guess yourself. Unless you sell at the absolute top of the market, you’re always going to leave some money on the table. For some, this can really irk; every cent the share price rises above their exit price is further proof they got it wrong.

For others, though, exiting a position can be less dramatic. For them, the exit price is the result of analysis already done — it’s implementing a strategy already in place.

For a trader who uses technical analysis, it might be the cross-over of two (or more) moving averages. A variation might be a price closing below a single moving average. And for those that draw trend lines, it might be the share price closing below support.

For those who use fundamental analysis, an exit could be triggered by a stock exceeding a price/earnings (P/E) ratio. It could be a change in perception of the sector it operates in, like the iron ore price breaking below a specific price, for example.

Whichever strategy you use, there’s another one that could generate more money than just selling shares at the current price.  And once you get your head around it, you might find it changes the way you look to exit your stock positions in the future.

Interested? Let’s take a look.

One of the most useful, but least understood, tools

Options are one of the most misunderstood tools available to investors. For many, they just go in the ‘too hard’ basket — something they’ll look at later, but never do.

But rather than a dull theory lesson, let’s see how you could implement just one option strategy to generate extra money on shares you’re looking to sell. Once you’ve got a basic options account set up, it’s a strategy that you can go into the market and implement straight away.

Please note that the following is for illustrative purposes and is not a recommendation.

Let’s say you own shares in Westpac [ASX:WBC] and your strategy tells you to sell. You could go online and place an order, and be out of the stock in seconds, with the funds landing in your broking account two days later.

At time of writing, a seller would receive around $29.15 for their Westpac shares. However, by writing/selling a call option over these shares, they could generate extra money by capturing something inherent in all options — time decay.

By writing a call option, the seller is obligated to hand over their shares at the option strike price, if the option is exercised, at any time until it expires. For locking in this obligation, the option writer receives a premium.

This strategy is called a ‘covered-call’. Meaning that you own the shares for which you’re writing the call options over. Writing a call option when you don’t own the shares is definitely something I don’t recommend, as it could potentially lead to unlimited losses.

If you take a look at the table below, I’ve put a red box around three different Westpac call options expiring in November — about 10 weeks from today.


Source: CommSec
[Click to enlarge]

The red box at the top shows a Westpac call option with a $29 strike price. By writing this option, the seller is locking themselves into selling Westpac shares at $29 if the option is exercised, even if the share price is trading higher.

With Westpac trading at $29.15, this option is bid at $1.02 and offered at $1.10. Taking the midpoint, the option seller would likely receive around $1.06 for writing this option.

So what have they done? Instead of selling the shares now at $29.15, they’ve agreed to sell the Westpac shares at $29 if the option is exercised before it expires in November. If that option is exercised, they’ll receive $29 (the strike price), plus $1.06 from writing the option.

I’ve put a red box around two other options — one with a $29.50 strike price and the other with a $30 strike price. The $30 option would produce a premium of around 58 cents and lock the writer into selling the Westpac shares at $30 if exercised.

With the $30 call option, that would lock in a sale price 85 cents higher than the current price if exercised, plus the 58 cent premium generated from writing the option. That’s around $1.43 above the current share price.

Remember, that’s if the option is exercised. It’s important to note that. Just because you write a call option, it doesn’t mean that the option will be exercised.

A call option is only likely to be exercised if the share price is higher than the strike price at expiry. It might also be exercised early if the stock has a dividend coming up, where the option buyer exercises it before the ex-dividend date to qualify for the dividend.

Always understand your risks and obligations

Writing a call option doesn’t protect the investor from a fall in the Westpac share price. If Westpac shares took a tumble, the investor would be exposed to the fall. Although the premium received from writing the option would help cushion the impact.

And as the ASX will require you to lodge the shares as collateral for the call option position (unless you have a higher level options account), you’ll need to close out the option position first before you can sell the shares. So keep that in mind.

It’s the bit about being exercised that is crucial in deciding whether to implement a covered-call strategy. There’s always the possibility the option won’t get exercised.

For someone using a covered-call as an income generating tool, this will be something they aim for. Each call option that expires without being exercised allows them to write another call option…and then another.

If an investor wants the funds now, though, a covered-call isn’t the strategy for them. Instead they’ll go into the market and just sell the shares.

However, if you want to squeeze out some extra cash — understanding that you’re still exposed to a fall in the share price — then writing a call option over existing shares can be a great way to generate extra money. As always, understanding the risks and obligations of the strategy is important.

A covered-call isn’t a strategy you’d use in a falling market — you’ll most likely be better off selling the shares and pocketing the proceeds. The best time to use a covered-call strategy is in a flat or range-bound market, where you can use the time decay of an option to work in your favour.

Regards,

Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.
Matt Hibbard

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