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A Strategy for Greater Returns. Part II: The Deep In-the-Money Covered Call (01/25/09 - Updated 01/25/09)

Richard W. Miller, Ph.D. 

I wrote in Part I of this series that in today's economic times it's hard to get a livable return on cash that you've accumulated.  This is particularly burdensome for retirees.  Six-month CDs return 2.9%, six-month treasuries 0.3%, ten-year treasuries 2.5% and triple A corporate bonds 4.8%. To add some perspective, if you had a million dollars to invest in one of these vehicles and hoped to live off the income, these annual returns would only provide $29,000, $3,000, $25,000 and $48,000 annually, respectively. This would hardly would be enough to live on, even for a millionaire. So, unless you wanted eat into your principal or to add income by working as a Wal-Mart greeter, a higher income strategy is needed, preferably one thatís conservative enough to be used in an IRA and, at the same time, one that carries less risk than just owning stock positions outright (and hoping they'll go up in value). Two option strategies meet these requirements: selling (or writing) naked puts and/or covered calls.

Our goal is to get a decent return on our cash, say greater than 15 percent annually, to minimize our risk and, if possible, to minimize the time required to incorporate and monitor the strategy. Note, since these strategies involve holding stocks, our benchmark risk is that of buying stocks at today's prices and holding them. Treasury vehicles, in particular, will always present less absolute risk, but for my money, that's only a slightly better strategy than putting money in a mattress.

I'll use Apollo Group (APOL) as an example for these strategies. It's been providing higher education to working adults for over 25 years and operates through its subsidiaries: the University of Phoenix, Inc., the Institute for Professional Development, the college of Financial Planning Institutes Corporation, Western International University, and Apollo Learning Group, Inc. This is a particularly good business to invest in with unemployment (and the resultant need for retraining) rising.  Zacks ranks it a one, and the next two years PEG ratios are 0.60 and 0.82. i.e., it has rising earnings and good value left at current prices.  And here's what its daily chart looks like.  The insert displays a portion of its February option string.

As an aside, notice the large price gaps marked with the white bars that have followed the last four earnings reports (the first down on poor earnings and the last three up). This behavior begs for another option approach (a long strangle or straddle) put on just prior to its next report (3/26/09). Notice, too, the nice bullish run since July.

APOL

Before looking at covered call opportunities, let's review the naked Put strategy one could use for APOL.

Writing the Naked Put

Our naked Put strategy might sell the February $75 strike and take in the $2.00 premium per share  or $1,000 for 500 shares (5 option contracts). The important numbers are contained in this next table.  Note, $1 per contract commission has been paid.

APOL NP


Writing this option position last Friday would return 2.65 percent on $37,500 tied up over the next 28 days (34.59 percent annualized). Further, considering Friday's close at $84.01, and if need be, we would be required to buy these shares for $75 each, there's 10.72 percent downside protection for any potential purchase. The most likely way this position will play out is that the option expires worthless; we keep the premium and don't wind up with the shares; and we repeat the process in March (likely with a different stock). Time wise, we monitor the stock for a few minutes each weekend to see whether things have changed (fundamentals, chart characteristics, etc.) then monthly look for another TSM candidate (another 30 minutes). If I had $100,000 to invest, I would try to establish three or four of these positions.

The bottom portion of the table addresses a hedging strategy, one that hedges the position's risk further by protecting against a catastrophic event.  It's created by buying the next lower Put strike (here the $70 Put) (creating a deep in-the-money bullish spread).  This costs $1.10 per share and lowers the premium taken in to $440 lowering our return to 1.17 percent over the remaining 28 days, but that still represents an annualized 15.30 percent return on our money.  In return, the maximum loss--even should APOL drop to zero-- would be limited to $2,060.  On the other hand, someone owning the shares themselves would endure a $7,005 loss or 18.68 percent if the stock dropped to $70.

Writing the Deep In-the-Money Covered Call

Occasionally, though not often, this naked Put strategy will deliver shares and force us to implement the second leg of our high yield strategy, one where we'll sell deep in-the-money Calls.  This phase is designed both to deliver our high yield and at the same time sell the shares we've taken in.

Let's say we're holding APOL shares and want to achieve our 15 plus percent annual return.  Let's sell the Feb $75 strike for its $10.80 a share premium.  Remember, APOL's current price is $84.01 so the real premium we take in is $1.79 ($75 + $10.80 - $84.01).  That represents a 2.13 percent ($1.79/$84.01) return for the coming 28 days and virtually guarantees that our APOL shares will be sold (called), because it's very unlikely that APOL's price will fall below $75 over the next 28 days (the only scenario where our APOL shares aren't called). 

Note, our return is even greater because most times we sell these shares for $84.01 but receive $9.01 immediately ($10.80 - $1.79) and the remaining $75 in 28 days so our real return approaches 2.39 percent ($1.79/$75) for the month.  Further, we have substantial downside protection (12.9% = $10.80/$84.01) should price fall during the month.  We don't start to lose money until price falls below $75.

There you have it, an easy 15 to 25 percent return on our money by implementing a dual phase option strategy: writing deep in-the-money naked Puts, written on quality stocks, followed, when necessary, by writing deep in-the-money Covered Calls.  Weekly, you'll spend a few minutes monitoring your positions, and monthly, you'll decide what to do for the coming month.  The TSM service will provides an ongoing list of viable candidates.