The first technique is called over writing, so let’s take a look see how it works. Before we start there is one difference between UK equity options and US equity options. In the UK one option contract relates to 1000 shares, but in the US one option contract relates to 100 shares of stock.

Imagine you have a portfolio of shares that you have held for some time and these are mainly UK ‘blue chip’ companies. One of your shares is British Airways which you have held for some time, and you have 1500 shares bought at 200p. The market price at the moment is 365p per share. It is June and you decide to look at the current option chain for the next expiry period which is September. The option expires on the 15th September. You look at all the strike prices available and see that there are contracts at 330p, 360p, and 390p. You check the premium of the contract at 390p and see that the premium is currently 16p. You decide to sell ONE contract for which you receive a premium of 1000 x 16p = £160. (the premium is multiplied by the number of shares for one contract i.e. 1000). Please note – you still have 500 shares left in your portfolio as you do not have enough to write a second contract. You have now sold 1 contract which obligates you to supply 1000 BA shares at 390p on or before the 15th September (Amercian Style Contract) to the owner of the contract if exercised in the period. In return for this you have been paid a premium of £160 which is yours to keep whatever the outcome of the contract. OK – lets look at the possible outcomes of this contract as follows:

Outcome A – the company becomes a takeover target and shares jump to 520p

In agreeing to the contract at 390p per share, you have lost out on the takeover news and have missed the opportunity of ‘making’ 1300 (130 x 1000) on your share holding. This is the downside of writing a call option on your shares, that you could miss out on a rise in prices during the contract period. This is undoubtedly true, however there is no guarantee that you would sell your shares at this point, in other words it is only a paper profit had you kept them. The £1300 lost ‘opportunity’ profits are offset by the premium you have received to £1140.

Outcome B – the share price falls to 295p as competition increases in the industry

The price has fallen during the period, and the contract expires. Whilst the price has declined by 65p, this is partly offset by the premium you have received, reducing your ‘paper loss’ to 49p per share. You still retain your shares and any future dividends.

Outcome C – the market is quiet and the share price closes at 390p

You have made a small ‘paper profit’ here, and a real profit of £160.You have kept your shares and any future dividends. The reason you would probably keep your shares is that with dealing costs etc it would not be worthwhile for someone to exercise, although you can never be sure. I have been exercised when the strike and market price close at the same price, but I have also been left unexercised with prices very slightly above the strike. It depends how your broker closes out positions and reconciles their contracts – sometimes you may be lucky, other times not.

Now, with B and C, you still retain your shares so what might you do? – write another call to earn some more income. You look to the next series (probably Dec) and write another option earning more income. With B, where the share is now trading at 295, you might look for a strike at 320 – 340, and with C, probably around 430 – 440. And so on, until on one contract you will be exercised. The most options I have written on the same block of shares is 4! Finally on the 5th contract the price went up and I was exercised. Please remember it is possible to write a contract so that you have built in a loss. Suppose you purchased some shares for 250p which then declined in price , and you wrote a contract at 225p with a premium of 10p. If it was exercised you would be receiving 235p (225+10) for shares you had paid 250p. Now, on occasion I have done this deliberately where I wanted to get rid of the stock for some reason. PLEASE DON’T DO THIS BY ACCIDENT. There are lots of packages around that will give you a graphical display of the breakeven point – most of these are free.

Finally, I mentioned dividends a couple of times above. Naturally, whilst you hold the shares you receive any dividend payments from the company. You should be aware when dividend payments are due for two important reasons. Firstly you may decide not to write an option as a dividend is payable in the next few weeks and you decide to wait. Secondly If you do write a call and a dividend is due shortly, the likelihood of exercise is much higher right before a dividend payment. The perfect outcome of course is where you keep your shares, your premium, and a dividend is paid during the contract ! – it does happen.

1. High Dividend Yield – Above 5 %

2. Moderate Dividend Payout Ratio – Below 50 %

3. Less Than 40 % Above 52-Week Low *

4. Options Available

5. Current Ratio: Over 1.5

6. Long Term Debt to Equity: Under .5

In part 3, we adjusted screen # 3 to: Over 50% below 52-week high”.

This adjusted screen gave us Olin Corp., (OLN), a Basic Materials/Diversified Chemicals company, which has two divisions -chlor alkali specialty chemicals and ammunitions for sports and the military.

Olin currently has a good dividend yield of approximately 6.2%, and their dividend payout ratio of less than 37% is very low for a high dividend stock. Olin’s 33% Debt-To-Equity ratios are strong and identical for both long term and short term debt.

Current Ratio: 1.9, meaning that their current assets are nearly twice as high as their liabilities.

OLN is also cheap by many other metrics:

Growth: A low PEG ratio of only .57 (investors look for PEG’s under 1)

Price/Book (P/B): Only 1.40

Price/Earnings (P/E): 6.17

Return on Equity (ROE): over 22%

Return On Investment (ROI): 12.24%

Return On Assets (ROA): 9.67%

Within their Diversified Chemicals peer group, they have the highest dividend yield and the lowest P/E ratio.

What if you want to be conservative and build a position in OLN at a price lower than its current market?

SELLING PUTS is a conservative high yield strategy which investors use to accumulate stocks at prices lower than the current market.

Each put contract sold potentially obligates the seller to buy 100 shares of the underlying stock. Brokers will vary in the cash reserve amounts they require a seller to post – some brokers want 100%, while others require less.

This trade example will use a 100% cash reserve, and no commission fees.

OLN is currently trading at $12.99.

1. Compare the cash yields of selling Nov $12.50 puts to the dividend yield:

If you were to buy OLN outright, at $12.99, you’d receive 2 remaining $.20/share dividends prior to Nov. expiration, which equals $.40/share, a 6.2% annualized yield.

OR

If you sold Nov. $12.50 puts,(OLNWV), you’d receive $1.60/share, a 28.5% annualized yield. Clearly, the put sale offers a much higher yield.

IMPORTANT CAVEAT: The put sale will be a short term gain, which is taxable at your personal tax rate, as opposed to the current 15% tax rate for qualified dividends.

Your Breakeven Price on this put sale is $10.90 ($12.50 strike-$1.60 put premium).

When the November expiration comes, there are 2 possible outcomes:

1. OLN declines to near or under $10.90, (($12.50 strike price less $1.60 put premium), and you are sold, (assigned), 100 shares of OLN at $12.50/share, (the put strike price).

However, your net cost would be $10.90, (the $12.50 strike – $1.60 put premium you received). This would put you approximately 21%+ over the OLN’s 5-year low of $8.97. A pretty reasonable price to pay for such a strong company.

2. If OLN doesn’t decline to near or under $11.90, your broker will release your cash reserve, and you walk away with $160.00 for every put contract you sold, a 28.5% annualized profit. (Either way, you keep your put premium $, whether you get assigned shares or not).

Many investors have been worrying about being left behind by the current rally. Selling puts is a way that you can still profit from solid companies, even though their prices have risen.

In the 5th and final part of this series, we’ll discuss other ways to analyze selling calls and puts.

Disclosure: Author is long OLN.

Disclaimer: This article is written for informational purposes only. Author not responsible for errors, omissions, or acts taken by third parties as a result of reading this article.

1. High Dividend Yield – Above 5 % (The S&P 500 average dividend yield is approximately 3.42%).

2. Moderate Dividend Payout Ratio – Below 50 % (The S&P’s payout ratio is approximately 59 %).

3. Less Than 40 % Above 52-Week Low

4. Options Available

5. Current Ratio: Over 1.5

6. Long Term Debt to Equity: Under .5

We then used the conservative bullish approach of selling covered calls to increase Cal-Maine’s already high dividend even further.

But, what approach can you take if you’re not so bullish on the market, which has gained over 35% since March 9, 2009, or, if you want to accumulate CALM at a lower entry price?

Instead of buying CALM at $24.93, (its June 1, 2009 opening price), a more conservative approach would be to sell covered puts on it, at a lower price. Selling a put on a stock means that you are selling someone the option to sell, or “put” the stock to you by a future date. Each put contract corresponds to 100 shares of the underlying stock.

Normally, most options aren’t exercised until near or on the expiration date,so the timing of possibly having the stock sold to you will depend upon what expiration month you choose. Due to the time value of money, if 2 options are at the same strike price, the one that’s further out in time usually commands a higher price. However, you should compare them on an annualized basis, in order to get a clear comparison of their returns.

How would this work?

First, you’d want to get an idea of this stock’s 52-week price range, which is $17.01-$48.80.

Due to the market’s decline before the current rally, and higher volatility, it has been possible in the last 8 months to profit by selling puts at or near a stock’s 52-week low. This is a rather conservative approach, allowing investors to “nibble around the edges”, instead of jumping in at a current higher price.

Looking at the option chain for CALM, and using the strategy of trying to sell a put as close to the $17.01, 52-week low as possible, we see that the August $20 put, (QKMTD), is currently priced at a $.75 bid, which equals 16.7% on an annualized basis.

There are 2 possible outcomes to this trade:

1. The stock has declined to or past your $19.25 breakeven point, (your $20 strike price less the $.75 put premium). You would then be sold 100 shares for every put contract you sold. The sale price would be $20.00, but your true net cost would be $19.25, (the $20 strike price less the $.75 put premium).

Owning CALM at $19.25 would place you just 13.2% above this stock’s 52-week low.

In addition, your $19.25 cost is 22.8% lower than the current price of $24.93.

ALSO, the $1.73/share dividend would equal an 8.98% dividend yield at this level, as opposed to the current 6.9% dividend yield level.

2. The stock doesn’t decline to or past your breakeven point. In this case, you’d walk away with a $.75/contract, 16.7% annualized profit.

Cash Reserve requirements: Brokers will vary on how much cash reserve they make you put up for selling puts. Currently, Schwab mandates a cash reserve equal to 100% of the value of the strike price times the shares you’d end up having put to you.

In our example, if you sold one $20 contract, which corresponds to 100 shares, you’d have to put up $2000.00 cash reserve.

Other brokerages, such as Options Xpress, require less cash reserve, which increases your leverage and your margins. However, if the stock does start to decline closer to your strike price, the broker may ask you to put up additional cash in reserve.

So, if you like a stock, but you think the market’s gotten ahead of itself, selling puts is another way to profit.

Disclosure: Author is long CALM.

Disclaimer: This article is written for informational purposes only. Author not responsible for errors, omissions, or acts taken by third parties as a result of reading this article.

A useful, conservative strategy that actually capitalizes on the market’s volatility to lock in high dividend yields is the Covered Call Selling or Buy/Write technique. The increased market volatility has increased call option premiums, giving investors the opportunity to sell high yield covered calls on many stocks, in effect giving them a one-time “double dividend”, reducing their initial investment cash outlay, and also offering them some downside protection. Since no company can cut the premium on their call options, these instruments are tantamount to an “ironclad” dividend. Indeed, the current call premiums are often giving investors higher yields than the underlying stock dividends. So, even if the company does cut its dividend, the investor will still retain the premium from his covered call sale. In addition, a call seller receives the call premium money back into his account upon settlement, (usually trade date plus 3 days).

Covered call writing also gives you the potential for capital gains, in addition to the high yields that you get from the call premium/dividend yield, should the stock be assigned, (sold), at expiration. Investors often sell covered calls that are approximately 5-20% above the stock’s current price, giving themselves the potential to realize an additional 5-20% profit, should these stocks rise past the covered call thresholds by the end of the investment term. Given the historic lows that many companies’ share prices have fallen to, many traditional value investors feel that they are buying these stocks at undervalued prices, and reason that there’s a very good chance of them rising in the future.

To illustrate this technique, let’s take a look at the prices for NYSE/Euronext (NYX),

as of March 4, 2009 market close:

STOCK COST/ SHARE: $16.36 

ANNUAL DIVIDEND: $1.20/SHARE

DIVIDEND YIELD: 7.33%

CALL EXPIRATION DATE: JAN. 15, 2010

CALL STRIKE PRICE: $17.50

CALL PREMIUM: $3.25

STATIC CALL YIELD: 19.86%

TOTAL STATIC YIELD: 27.19%

TOTAL POTENTIAL ASSIGNED YIELD: 34.16%

As you can see from the yields in this example, this stock’s 19.86% call selling yield is 2.7 times its dividend yield of 7.33%. So, even if they were to cut their dividend, the investor in this example would still have nearly 20% downside protection. If the dividend remains intact, the downside protection in this trade is 27.19%, equivalent to the total static yield, (the combination of the dividend and call yields).In addition, by selling a call at the $17.50 strike price, approximately 7% above the $16.36 cost/share, this investor also has the potential to for a total assigned yield of 34.16%, making a very compelling case for this strategy.

Trade Summary for this Example: 

Breakeven: $11.91 

Maximum Share Reselling Price: $17.50 

Static Yield: $435.00 

Potential Assigned Yield: $559.00

Investment Term: 10+ months (The Annualized Yields would be even higher than the yields listed above).

Definitions:

Static Call Yield: The yield realized when the underlying shares are NOT assigned/(sold) at or before expiration. In a “static” scenario, the stock’s share price doesn’t rise above or close enough to the combination price of the strike price, plus the call premium, to make it worthwhile for the shares to be bought by the call buyer on the other side of the trade. In the above example, the share price would have to rise above or near $20.75, ($17.50 strike price plus the $3.25 call premium), to make it worthwhile for the call buyer to exercise his option to buy your shares.

Total Static Yield: The combined dividend and static call yields.

Assigned Call Yield: The yield realized when the underlying shares ARE assigned/(sold) at or before expiration. This normally occurs when the stock’s share price rises to or above the combination price of the strike price, plus the call premium, causing the shares to be assigned, (sold), at the strike price, which in the above example is $17.50.

Risks and Limits: As with any investment, there are risks. Obviously, this strategy can’t guarantee that these stocks won’t decline further in value once you’ve bought them. However, this value-based, “double dividend” covered call strategy will at the very least give you more downside protection than if you had only bought the stocks outright, and the call premium lowers your cost basis.

Upside Risk: Since this strategy quantifies the upper limit of your profit potential, you should be aware that, even if the stock appreciates far past your strike price and call premium, you’ll still be obligated to sell it at your covered call strike price, which places a limit on your profit potential. It’s usually wise to research the call’s theoretical value in an options pricing model, such as Black-Sholes, before placing the trade, to ascertain the chances of the call ending up in the money at expiration. You should always analyze your static and assigned gains, and breakeven point before placing any Covered call, (Buy/Write), strategy. Many of the online brokers have automated options pricing calculators that simplify this process.

Downside Risk: The biggest risk factor in selling covered calls is that you are putting much more money at risk here than by merely buying a call option. However, research has shown that the odds tend to favor option sellers over buyers. You should make sure you research any stock thoroughly before executing this or any other strategy. However, as noted before, if the stock declines past your breakeven, you should be able to offset some of the loss by “buying back in” your sold calls at a profit, and perhaps rolling into a lower strike price call, if you want to maintain your underlying position.

copyright 2009 DeMar Marketing. All Rights Reserved Worldwide. This article was written for informational purposes only. Readers should not make any investment decisions based solely on the information in this article.

My pal was a normally a mild-mannered sort – very reflective, always weighing the consequences rationally before acting. In short, a logical thinker.

Imagine my dismay when that one phrase, “trading options”, triggered this unprecedented tirade. You’d think I’d insulted his family or something even worse.

After a few seconds had passed, I realized the reason for my friend’s outburst. He, like so many other investors, had only lost money trading options.

Why? Because he’d never discovered the number one option trading secret: 3 out of 4 options expire worthless. You read that correctly, when you trade options as a buyer, you have a 25% chance of making money, and a 75% chance of losing money.

This is why professional traders and investors favor the option strategy of selling options, rather than buying them, in hopes that the trade will go their way.

“Wait a minute. How can all of those options just expire worthless? I’ve seen ads for 100’s of option strategies and trading systems on the internet. They can’t all be losing money.”

I had to smirk. Now I really had him thinking. He knew that I hadn’t yet told him the big “secret behind the secret”, but he couldn’t quite put his finger on it.

“I have one word for you, my doubting friend”, I said,…”Time”. “When you become an option seller, you have time working FOR you, instead of against you. The reason is simple – as puts and calls get closer and closer to their expiration date, they lose their time value, due to “time decay”, or theta, the Greek letter that option traders use to denote the % of change in time value of an option.”

This is true of any option, no matter if you’re buying or selling call options or put options, or using a covered call strategy. It’s one of the big secrets of options investing that doesn’t get written about too often.

Because of the power of time decay, you can actually guess wrong about the direction of the market, or a stock, and you’ll still make money selling a call option or put option, as opposed to the buyers on the other side of the trade, who not only have to guess the stock’s future price movement correctly, but must do it BEFORE the option expiration date.

This helps to explain why even conservative investors use the covered call strategy, which is widely considered one of the most conservative option trading strategies around.

To sell covered calls, you must own at least 100 shares of the underlying equity, since each call contract corresponds to 100 shares of the underlying stock.

This is a tool you can use to hedge your portfolio, and lower your risk, by receiving “call premium” money, which lowers your break-even cost basis.

Selling covered calls is a short-to-mid-term option strategy you can use to double and triple your yields on new stock purchases, and/or to earn more income from your existing portfolio.