Is a Buy-Write Fund Right for Your Retirement Account?

This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details.  The key things you need to know about buy-write funds are:

  1.  They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
  2. They are more volatile than bond funds but less volatile than stock funds.
  3. They won’t go up as fast as stock funds, but also won’t go down as much.
  4. You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
  5. They will perform the best of anything when markets are stagnant.

So there’s the minimal you need to know.  For those who want more explanation, please read on.

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What are call and put options?

You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company.  An option is a legal contract between two people.  This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date.  An option to purchase is called a call option, where the option to sell is called a put option.  It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer.  The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.

Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t.  A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now).  As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money.  Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.

To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date).  For example, this month all of the options expire on Friday, March 16th.


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Why would someone buy options?

Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price.  They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money.  Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house.  If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit.  This is really good for a one-year speculation.  If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit.  Leverage magnifies potential gains.

Options do the same thing.  You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock.  If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit.  (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.)  If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock.  This is why people use options, the potential to make a fast profit without putting too much money down.  This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them.  You therefore need to be right about both the direction and the timing.

What about writing options?

The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium.  The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer.  The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date.  Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time.  While the option buyer has the potential to make a lot of money, most of the time he doesn’t.  Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.

For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side.  You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return.  Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive.  It is like being able to make any stock into a dividend-paying stock.

Writing covered calls is not without risk.  If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never).  You are also setting a limit on your potential return.  If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money.  Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns.  In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower.  It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.

Is there an easier way than writing calls yourself?

Yes.  There are mutual fund companies that create buy-write portfolios for you.  For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio.  You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping.  In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing.  For example, in 2017 the fund provided about 11% in cash payments.  This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.

Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year.  For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%.  With income investment, however, you should be focused on the cash return you are getting and not the share price.  The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year.  In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Ways to Delay Capital Gains

One of the main advantages in long-term investing is the ability to delay capital gains taxes.  This allows the money you would have been paying in taxes to compound and grow more income for you.  This is true even in a taxable account.

Even if you do sell stocks and pay capital gains taxes regularly, there is a tax advantage to holding stocks for more than a year.  While this rule changes from time to time, currently you will pay between 0% and 20% in capital gains taxes for long-term gains and ordinary tax rates for short-term gains.  Note that for some reason it is thought that those who invest for long periods of time are helping society and therefore deserve a lower rate than those jumping from stock-to-stock, or perhaps politicians are trying to encourage people to invest for longer periods of time since this is a good thing to do.  In any case, there is currently an advantage to long-term holding, meaning holding stocks for a year or more before selling and realizing a gain will lower your taxes.

But what if you buy a stock and it shoots through the roof in a couple of months?  Maybe you planned to hold it long-term, but now the price is so high that you worry it will sit there for years, waiting for earnings to catch up or perhaps even fall back to earth once the excitement dies down.  Or maybe you need the money in a year, but know your income will be a lot less next year than this year, so you want to move the gain by a few months and reduce your tax burden.  (Note, all of this could be avoided if the Fair Tax were enacted.  Please read my posts on the Fair Tax and support it so we can get back to worrying about investing instead of taxes.)  In general the best thing to do is to just sell the stock since the price can easily drop enough to wipe out any tax savings you would have had.  Nevertheless, today I thought I would provide some ways to delay the realization of capital gains.

As with anything tax related, please check with a CPA or do your own review of the rules at the IRS website, rather than believing some guy on a the internet.  These rules change all of the time. 

Using Put Options to Insure Your Gains

The first method to prevent a loss is to buy a put option on the stock.  This is an insurance policy that guarantees that you can sell the stock for a certain price, called the strike price, on or before a certain date, called the expiration date.  For example, let’s say that you own 1000 shares of IBM, which is currently trading for about $180 per share, and wanted to hold it through next December to put your gain into 2015 instead of 2014.  Looking at the options for IBM, you could buy an IBM January 2015 Put Option with a strike price of $180 for about $1200 per 100 shares, or about $12,000 for all 1000 shares, valued at $180,000.

This would allow you to sell your shares to whomever sold you the put option for $180 per share no matter the price at which the stock was trading.  You could do this anytime between now and the third Friday in January.  At that point, if you did not sell the shares using the put option, the option would expire worthless (you are paying for an insurance policy).  If the stock went up to $250 in the mean time, you could just hold onto the shares and sell them for $250, letting the put expire.  If the price fell to $100 per share, however, you could still sell the shares for $180 each in January by exercising the put option.  If you wanted some protection but didn’t want to pay $12,000, you could also buy the January $170 puts for $8.00 per share, or about $8,000 to cover the 1000 shares.  This would allow you to sell the shares for $170 per share, which would result in a little more of a loss if the share price did fall, but would allow you to keep more of the gain if the share price held up between now and January.  This is kind of like having a higher deductible on your car insurance, which means you pay more if there is an accident but you save money when there is not.

Selling Short Against the Box

A second method is to do what is called selling short against the box.  In this strategy you tell your broker you would like to sell short against the box the same number of shares as you hold long.  You would then keep both positions open until the point at which you wanted to realize the gain, at which point you would tell your broker you wanted to liquidate the position.  He would then cause the two positions to cancel each other out and you would effectively have sold the shares.  (Note that this has no reason for existence other than to delay capital gains for taxes and some lawmaker may have changed to rules to disallow this transaction; therefore, check with your CPA and/or your broker before trying this maneuver.)

As an example, let’s return to our holder of 1000 shares of IBM.  He would tell his broker that he wanted to sell short 1000 shares of IBM against the box.  His broker would borrow the shares and sell them, putting an entry for 1000 shares of IBM short in the investor’s account.  From that point if the stock went down in price, the short sale profit would exactly cancel the growing loss on the shares held long.  Likewise, if the stock went up in price the loss on the short sale would be cancelled out by the gain on the shares held long.

There are issues and a cost to this strategy as well.  Selling the shares short will result in additional commissions and fees that the investor would not need to pay if he just sold the shares instead.  The short sale would also result in a possible margin position.  For example, if the stock increased in price and there was not sufficient cash in the account to cover the value of the short sale, the brokerage firm would start charging margin interest for the uncovered value of the short sale.  If the stock rose high enough the brokerage firm might make a margin call, forcing the investor to come up with more cash to cover a larger portion of the amount of the short sale or close the position early.

As said before, it is usually best to just sell the shares and pay the taxes.  If the tax savings will be large enough, however, such as for someone in the top tax bracket where the income taxes would be around 40% for a short-term gain versus 20% for a long-term gain, using one of the above strategies may be worth consideration.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Covered Calls Expire this Week

For those following my covered call writing saga, we’re coming down to the wire.  The calls I wrote on BJ’s Restaurants expire next Friday.  Since this is the last week and they are “in the money,” meaning that they are above the price the person who bought the calls can purchase them for, chances are good that they will be purchased this week.  It would probably happen at the last minute, but because they are American style calls, it could happen at any time.

As I always seem to find when I deal with options, there was one point where I could have jumped out if I’d been very deft and done well.  A few days after I sold the calls the share price of the stock dropped down into the low $33 range and the calls went from $1.40 each to $0.25 each.  I could have made maybe $0.90 per call after brokerage fees in only a few days – not bad.  The question at that point, however, was whether the stock would stay down, or go down further, in which case they would expire worthless and I could save the brokerage costs by staying put.

Of course, the stock instead rallied over the next few days, pushing the price of the calls back up somewhat — although not as high as they were — and making it likely that the stock will be purchased.  This isn’t a terrible thing.  I purchased the shares around $31 per share, so I’d make a nice profit and get to keep the proceeds from the calls.  I’m just not sure I want to sell at this point, so I’m looking at my options (pun not intended).

At Friday’s close, the stock was at $36.53 per share.  The May 35 calls I wrote were at $1.66 per call.  Note that their price is getting pretty close to the difference between the stock price, $36.53, and the strike price, $35.  Because there is not a lot of time left before they expire, the time value of the options is decreasing towards zero. (Time value is the value of the options beyond the difference between the current price and the strike price due to the fact that the speculator may be able to make money by purchasing the options and using the leverage they provide to make bigger percentage gains than they would by simply buying the stock.  The closer you get to expiration, the less likely that is to happen.  Another way to think about this is as the premium you pay for insurance that you will be able to buy the shares for the strike price.  Like any insurance policy, the less time the policy covers, the less valuable it will be.)  With only a week to go, the stock will probably close above the strike price on Friday, although this stock does move quite a bit so there is a chance it will not, especially if the rally we’ve been having falters.

Here are my options:

1) Hold pat and let the shares be purchased for $35.  I would make a profit of about $4 per share plus the $1.40 premium on the options.  I confess I would kick myself if the stock then proceeded up to $40 per share or something, although I do have additional shares.  I would be happy though if they fell back into the low $30 range where they had been trading and I could buy them back for less than for what I sold them.

2) Buy the options back, take a loss on the options, and hold the stock.   I could buy a set of May calls to offset the calls I wrote and close the position.  At $1.65 each I would take a loss of $0.25 per option plus a couple of hundred dollars in commissions, but this would be less expensive than selling the shares and then buying them back again.

3) Roll the options into June or July.  The June $35 calls are currently selling for $2.05 each and the July calls are selling for $2.55.  I could buy back the May calls and then write the June or July calls.  This would net an additional $0.40 per call for the June calls or $0.90 for the July calls, before commissions.  After commissions it would probably be $0.20 and $0.70 per call for the June and July calls, respectively.  This would be a good move if the stock stagnated and especially if it fell since the premiums I would receive would offset part of the loss from the drop in share price.  Given the big gains stocks have made this year, that might be a good move since they may be due for a breather.  Then again, if the stock continued up, I’d have an additional month or two to  wait while my short position grew ever bigger.

4) Roll both out in calender date and up in price.  I would write July $40 calls and buy back the May $35 calls.  The July $40 calls are selling for $0.40 per call, so this premium, combined with the $1.25 per call I received when I wrote the May $35 calls would just cover the cost of buying back the May $35 calls.  If the stock continued upwards, I’d be able to make an additional profit until the stock crossed the $40 mark.  If the shares fell, however, I really wouldn’t have any additional protection.

Right now I think I’ll go ahead and let the stock get sold.  As I’ve said, I have additional shares beyond those on which I wrote the calls, so if the stock keeps climbing I will make a nice additional profit, so things wouldn’t be so bad.  If the stock falls back down, I can use the cash I got from the sale to buy more shares at a lower price and maybe write some additional calls.

I can’t help thinking though that I’d have been better off just holding the stock.  If the shares sell at $35, I will make a profit of about $400 per 100 shares from the appreciation on the stock plus $125 per hundred shares from the options, for a total of $525 per hundred shares.  If I had just held the shares, I could sell them for $36.53 per share right now and make about $553 per hundred shares.  I would probably be feeling differently if the shares had stayed below $35 per share since I’d be getting some income despite the fact that the shares were going nowhere, but it seems like I can usually do better just holding the shares.

My father used to say that if your broker sends you a Christmas card, you’re trading too much.  It seems like writing covered calls results in trading too much, often generating more for your broker than you receive.  Then again, maybe the way to look at them is a way to lower your risk, much like buying bonds.  You give up a bit in potential return versus holding a basket of growth stocks outright since your gains will be limited when stocks are going up, but you feel better when stocks are stagnant or going down somewhat since you either make a decent return (better than bonds) or don’t lose as much.  Theoretically you could do better writing covered calls than you would holding index funds since the potential returns are around 20 to 25%, versus 10-15% for the market in general, but it seems like holding individual stocks – the right stocks – provides the best return.  The problem is finding the right stocks.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.