Wednesday, January 6, 2016

Goal Update: End of December 2015 And A Stock Option Primer

At the end of each month, I post an update of my goals, including a brief discussion of any notable events that might have occurred during the month. The latest month's figures can always be found under the Featured menu in the menu bar at the top of the blog.

Last updated: End of December, 2015
Current value: $20,001
Change from last month: +$1,300
Percent of Goal:  18.40%

click to supersize

Note that the funds in this account are invested in stock, so there will be fluctuations in value that are outside my control. I never withdraw money from this account, so any dips are purely due to stock price changes.

Events Of Note Last Month:

Income this month from my online courses sales was $276.My account took a big jump in value thanks to Realty Income stock taking off. More on that below. I've also unlocked a new achievement this month:

I squeaked across the $20,000 threshold. It was December last year when I hit the $10,000 saved mark. Looking back at the last year, my contributions to this fund totaled $7,442. To put it another way, $2,558 this year came from investment gains - just over 25% of my increase this year. That shows the difference between just saving and investing money.

At $10,000 per year, I'm looking at another 8 years before I will reach my goal. However, as I accumulate more savings, my returns will start compounding and that time frame should come down.

As I mentioned last month, because I'm getting close to the point where I will be selling my shares of Realty Income and moving the money into a hard money loan, I started looking at a way I might be able to wring a bit more money out of the stock before selling it. One way to do that is with stock options. Specifically, by writing covered calls.

A Short Stock Option Primer

Calls and puts are types of stock options. A call gives the owner the right, but not the obligation, to buy a stock at a certain price. Similarly, a put gives the owner the right, but not the obligation, but sell a stock at a certain price.

Those definitions are written from the perspective of the option buyer. From the perspective of the option seller, it is reversed: selling a call gives the seller the obligation to sell the stock at the specified price (should the buyer of the call want to exercise, or use, the option). Selling a put gives the seller the obligation to buy the stock at the specified price (again, should the buyer of the put want to exercise the option).

(I'm going to stick to calls for the remainder of this discussion, as people tend to have an easier time comprehending those than they do with puts, for some reason.)

Some other things you need to know abut options: One option covers a block of 100 shares, so a single call option gives the owner the right to buy 100 shares of stock. The buy or sell price of the underlying stock that the option is written for is called the strike price. Options are only good for a limited time and the day they expire is called the expiration date. Although one option covers 100 shares of stock, the option price is quoted on a single share basis, so the cost of an option is 100 times the quoted price.

The Terminology Of Buying And Selling Options

Selling a call or put is referred to as writing a call or put. You can write two types of options: covered or naked. Writing a covered call is selling a call where you own the underlying stock. Writing a naked call is a call where you do not own the underlying stock. For instance, if you write a call option for IBM and you own 100 shares of IBM, you have sold a covered call. This is because if the option buyer exercises the option, you must sell him or her 100 shares of IBM stock, which you already own. If you sold the call option and you did not own IBM stock, this would be a naked call. In that case, if the buyer of the option decides to exercise the option, you are required to buy 100 shares of IBM stock to sell to him. The problem is that IBM shares may now cost more than the strike price of your option, so you would lose money in this case.

Obviously, selling naked calls exposes you to unlimited losses. Suppose you sold an option to sell a stock for $10 per share in 30 days at an option price of $1 per share. By selling this option, you collected $100 up front. Fast forward 30 days and now that stock is trading for $75 per share. The option buyer comes to you and says "Here's $1000, give me my 100 shares of stock." Because you didn't actually own the stock, you have to go buy 100 shares at the current price of $75 and sell them to the option holder at $10, giving you a net loss of $64 a share (the difference between what you had to buy the shares for and what you had to sell them for, including the $1 per share you received for selling the option in the first place). Selling naked options is extremely risky.

Writing covered calls, on the other hand, is much more conservative. Let's look at the same situation, only this time, you own 100 shares of the stock. The option buyer comes to you and says "Here's $1000, give me my 100 shares of stock." You already own the stock, so there's no problem. You do have some "fictional" losses. You have to sell at $10 per share instead of the current market price of $75 per share, so you didn't make as much money as you could have. Hopefully, you bought these shares originally at less than $10 per share, so you still made some money.

If the option expiration date arrives and the stock is below the strike price, the option expires worthless. You, as the person who sold the call, gets to keep the money the option buyer paid you. The option buyer however, is out of luck. He or she loses the money paid for the option and gets no stock in return. Since no one can tell where a stock price is going in the future, buying options is pretty much legalized gambling. Selling options can be viewed the same way, however, it makes a bit more sense if you are in a situation like me, where I am planning on selling my stock anyway.

Got that?

It can be complicated. Let's walk through what I did:

On December 22, I wrote 3 covered calls for Realty Income stock at a strike price of $50 with an expiration date of Jan 15, 2016 at a price of $1.70. So I received 3 * 100 * $1.70 or $510 for this. The stock was trading at 51.18 at the time, so this is a bit of a premium over the current price ($51.70 per share versus $51.18 per share).

What happens now? I sit on my stock until January 15, 2016. On that day, if the stock price is below $50 at the close of trading, the options expire worthless. I get to keep that $510 and my stock. If the stock price is above $50, I will likely have to sell it at $50 per share. But keep in mind, I already collected $1.70 per share when I sold the option, so if the stock closes between $50 and $51.70, I've made more than I would have just selling the stock outright. If the stock closes over $51.70 per share, then I will have lost out on some potential profits because I will be forced to sell at a below market price. Overall, though, I will still have made a profit because I originally paid less than $50 each for my shares.

Why Bother?

Why did I do this? It's a complicated process and I've got the potential to miss out on some profits. Why wouldn't I just hold onto my shares and straight up sell them later? Because I don't believe the price of the stock will go much higher. (It's near a 52 week high and the Fed has started raising interest rates, which typically causes REIT stocks to drop in price.) In effect, I'm betting that, come January 15, the price will be below $50 per share. In that case, I'll have received an extra $510 for nothing. Its a way to squeeze a little extra cash out of the stock before I sell.

And if the stock ends up above $51.70 per share? Meh. No big deal. I was looking to sell anyway.

Another factor played into my decision to sell the covered calls: I want to move $20,000 into a hard money loan. Right now, my partner is getting 8% interest on loans. For $20,000 that works out to $133.33 per month. So the $510 premium I am receiving for three and a half weeks (Dec 22 to Jan 15), is more than I could earn from the loan, so this was the better investment.

I'll keep you posted on how this turns out. As of the time I am writing this, December 31, the stock closed at $51.63.


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