Leveraging an Investment for Additional Profit
Cake is good. Chocolate cake is particularly good. Chocolate cake with chocolate frosting is wonderful. Each layer of a chocolate layer cake with frosting just adds to the appeal. I don’t even need ice cream on the cake, but if I get ice cream, I like chocolate for the cake topping as well.
Investing can be done in layers as well. Layer one for most investors is to buy low and sell high. Others, like myself, also know the value of the dividends layer, especially long-term dividend growth. Some day trade, hoping to score daily wins and minimized a loss by getting in during an upwards trend and exiting before the day is over. But there is third layer for a patient investor to consider to realize some profit from an investment they hold.
The one-profit method most take is to buy an investment and hold it long enough to see the price rise. They then sell some or all of their investment. Today’s example includes this strategy. The two-profit approach is to purposefully buy a dividend growth investment to bolster their capital gain with cash from dividends. That combination can be profitable. I used this approach too. The three-profit approach adds another possibility for profit. It has to do with something called “options.” The method with the least risk, if done right, is the covered call. And, yes, I did this too.
Sell at Market or Sell a Covered Call?
You can sell your stock for cash at any time at the market price. You can, as an alternative, sell the right to your shares at a predetermined price with a specific expiration date. If stock XYZ is selling for $10 today, I can sell my 100 shares for $1,000. A week from now those same shares could be trading for $11 per share and I could sell them for $1,100 then. But I could sell an option, a covered call, for a price greater than $10 and still own the shares if the price doesn’t rise above the predetermined price.
For example, I could create a covered call for my 100 shares of XYZ to offer my shares for $0.50/share if the price rises to $11 by a week from Friday. If the price rises to $11.50, I am committed to sell my shares for the $11. I get my predetermined sale price and I get to keep the profit from the covered call sale. That profit would be $0.50 x 100, or $50. If, however, the price never rises to $11 before the expiration date, then I get to keep the $50 and the shares remain in my account. I can then enter another covered call, if I so desire, and try to earn another small return on my shares. This would be in addition to any dividends that XYZ might be paying. Therefore, the three layers of profit for XYZ would be the gain on the sale of my shares, any dividends I have received from XYZ during the time I owned the shares, and the profit from the covered call.
Which Covered Call Should I Sell?
The next step is to choose the right call to sell. There are scores of choices, but only a few are good candidates. I prefer to hold stocks for the long term. Because of this, some of my positions are ones I would not use in a covered call strategy. I consider shorter-range holdings if I can combine the following:
- Good annualized yield. If possible, I want the XYZ stock to pay a decent yield of 2-3%.
- Capture the dividend if possible. I want to hold the shares long enough to get some dividends.
- Reasonable absolute premium. I want the price I get for the sale of my covered call to be sufficient to make the work I am doing worth my time. It takes less than 30 minutes of my time, so I like to shoot for at least $25. Most of the time I get more than that.
- I don’t usually want to sell during a time when earnings will be announced soon or when an ex-dividend date is near.
- Finally, I want to pick a reasonably soon expiration date. I don’t want to have my position locked up for more than 2-3 weeks. I want a short time period, for rapid time decay. This takes more work but may generate better returns.
What Are The Next Steps?
Covered calls expire on Fridays. If today is Monday May 11, then I look at covered call prices for May 15, 22 and 29 but no further out than the first Friday in June. I then check to see if there are any key events between today and the first Friday in June to see if there is an earnings announcement or an ex-dividend date.
The first layer: Book Some Profit
I have used this three-layer strategy with Kroger Co, (KR). This shows several aspects of the strategy, including not buying all of the shares I want immediately. I bought a total of 300 shares, each time buying at a lower price to lower my average cost. I then sold the last two lots for a profit of $1,263.41. This was a gain of 28.9% in less than two years. At the end of 2017 I still owned 100 shares with a cost basis of $3,262.50. This lot called for more patience.
The second layer: Collect the Dividends
During the time I owned shares, from 2016-2020 I received fourteen dividend payments. The total dividends added $227.50 to my cash. Not a huge amount, but still more cash. The total gain at this point was $1,490.91 from layers one and two.
The third layer: Sell a Covered Call
Because of the Covid-19 virus, companies like Target, Walmart and Kroger saw increased foot traffic. Each saw their share prices increase after some of the worst news had passed. I determined that it was time to sell my remaining 100 shares if I could get $33.00 per share. That would not be a great return after holding the shares for more than three years, but it wouldn’t be a loss. I decided I would offer my shares for $0.22/share with a call expiration date of May 8. I entered the order on April 30th and a buyer quickly purchased my order. As a result, I received another $21.30 after commissions and fees as profit.
The final layer: The KR shares are called
Because the price of KR shares rose to $33.00, I was obligated to sell them. It could be argued that I was too hasty because the shares closed at $33.73 on May 11, 2020. However, I now also have the cash from the sale of $3,299.92 to invest in my next idea.
Excluding dividends and the proceeds of the sale of the covered call, I realized a profit of $1,300.83 for my 300 shares. While my first lot of 100 shares was a disappointing drag on the total return, my strategy helped me avoid a loss and added cash at appropriate points for reinvestment elsewhere.
My next post will provide an example to show what happens if you don’t have your shares called away. More opportunities exist for selling another covered call on the same investment. In other words, if your shares aren’t called away by expiration, you can enter another covered call. It is like adding another layer on your cake!