The Tycoon Report

How To Double the Yield on Treasuries by Using Options

Thursday, August 24, 2006 | Chris Rowe

Many people are talking about buying stocks at bargains these days.

If you have been reading what I have been writing lately about a) this time of year typically being a bad time for the bulls & b) this typically being the worst year for the bulls out of the four year "election cycle," then you may be thinking twice about taking any kind of a bullish stance at all right now.

But the truth is that many people feel that right now is a safe time to invest, with PE ratios being so low, and with the trend of an increasing number of stocks, within most sectors, trading below their bullish support lines, (which is a contrarian indicator.)

Yesterday my Aunt Stacy, who is an Occupational Therapist, told me that she wanted to take 80% of her money out of the market to reduce her risk for now, but didn’t want to put it in something (I think the term she used was) “boring.”

She said “Chris, I read your last Tycoon Report that sounded a little gloom and doom-ish. I’d rather invest in the market when stocks are cheaper. In the meantime, what do I do if I still want to make money? I want safety, but I don’t want to sit around in a money market fund, or Treasuries which will only pay 4.8% - 5.00.”

First I told her that I was impressed that she had learned so much. Then I said “I have a solution for you.”

She said “Let me guess, your solution is related to options. I don’t want to get fancy.”

I assured her that this wasn’t going to be a complex strategy, and that it fit exactly what she wanted to do. I told her that this would be one of the most conservative strategies, that anyone can use, even in a retirement account where most options strategies are not allowed (since many are very risky.)

I said that the strategy that I was about to give her is not one that we typically use at The Trend Rider. (The Trend Rider uses strategies which are about mid-risk, with average returns on closed out trades being just under 22%, sometimes in less than a week.)

This strategy is designed to yield you more than the 4.8% - 5% that you would get in treasuries, so we will shoot for 8% - 9% returns. And again, it puts you in the position to own stock at a significantly reduced cost basis.

Here we go …

If you already understand the concept behind covered calls (aka covered writes,) then this will be easy. Writing covered calls that are very deep in the money can be a great alternative to fixed income, or cash.

The strategy that I am about to tell you about is called a “Buy Write”

I’m not talking about buying a stock at $21.00 and selling someone the right to buy it at $20.00. I’m talking about buying a stock at $21.00, and selling someone the right to buy it at $15.00.

You should make sure that you choose a stock and option that is going to yield you the amount that you are looking for. In our case, we are looking for something over 9%. I will give you the calculation below so that you can apply it to different stocks.

It may take some time to find the right stocks for the job. Be sure that these are stocks that you wouldn’t mind owning at cheaper prices, and preferably ones that seem to have strong support on the charts.

The goal is to be called away (or called upon to deliver, or sell your stock at the strike price.)

Let’s use an example (One of the examples that I gave my aunt):

Sun Microsystems (Symbol: SUNW). Ever heard of them? It’s a little $16.7 Billion computer system company on the NASDAQ.

The stock trades at $4.77. I took a look at the option chain for Sun Microsystems which can be found for free (usually 20-minute delayed) at Yahoo Finance, CBOE.com, and most other quote services.

The options with more time left before expiration are more expensive, and in order to get the return that you want, you should look at options that expire at least 3-5 months out or more.

So I went to the options that expire in January (5 months.)

As you can see below, I have highlighted the January 4.00 call options. Each option represents 100 shares of stock.

If you write (or sell) this option contract, then you are selling someone the right to buy 100 shares of SUNW from you at $4.00. If you sell 10 of these options, you are obligated to sell someone 1,000 shares at $4.00 if you are called upon to do so, and so on.

Two important notes:

-Stock options expire on the third Friday of the month, so this one expires on January 19, 2007.

-This call option is at $0.95-$1.05 so if you sell it at the market, you will sell it at $0.95. This means you will receive $0.95 for each call that you sell X 100. (Each option contract represents 100 shares so you receive $95.00/contract.)

Keep in mind that this example does not include trading expenses, so you will have to factor that into the equation, depending on what you are typically charged for a trade like this. But you probably would not want to do this with only 100 shares and 1 option contract, since commissions may eat into your profit, defeating the purpose. Let’s use 10,000 shares and 100 option contracts for example.

The strategy, which is called a “buy write,” involves buying the stock while simultaneously selling the matching number of call options. If you don’t know how to do this simultaneously, just call and ask your broker how to do it.

EXAMPLE: You can buy 10,000 shares of SUNW at $4.77 and simultaneously sell 100 January 4.00 calls at 95 cents. (Remember each option contract represents 100 shares, so 100 contracts represents 10,000 shares.)

This will give you a cost basis of $3.82, and you will only be required to come up with $38,200.00 (not $47,700.00 for the entire stock transaction.) So you are profitable on this trade unless it trades under $3.82.

(Remember, you wouldn’t mind buying stock if it trades lower from the current price anyway.) I’m comfortable with owning SUNW at $3.82 anyway, but our hope is to get called away from the stock.

Now, I like Sun Microsystems specifically, because if you look at the charts below, you can see that owning it at $3.82, isn't a bad deal. The red line indicates the price level of $3.82.

(3 year chart of SUNW)

(Still not convinced? Okay, here's a 10 year chart):

Here are the possibilities:

Scenario #1) You get “called away” from the stock at the strike price of $4.00. This means that you are called upon to deliver the stock, or sell the stock at $4.00.

This will happen automatically, so don’t worry if you are out of the country or visiting Mars or something. If your broker can’t contact you, you will come back home and find cash sitting in your account instead of SUNW stock. In this case, if 10,000 shares of SUNW were the only position, you would find $49,500.00 in your account minus commissions ($40,000.00 paid to you for 10,000 shares of SUNW at $4.00 100 contracts which represents 10,000.)

This means that you have an 18-cent profit on SUNW. Remember, since this is a very safe strategy, we have limited upside here. The most that you can make is 18 cents, but our goal was to find an investment yielding more than treasuries right?

18 cents on $3.82 is a 4.71% return in 5 months. That is an 11.3% return on an annualized basis (again, before commissions.)

That is almost the same annual return that the major stock market averages have returned on average for about a century.

Also Keep in mind that the above example assumes that SUNW gets called away from you at the expiration date of January 19, 2007. But the reality is that the stock can be called away from you at any time before options expiration. So the earlier that you are called away from the stock, the higher your annualized return will be. If you get called away in 2 ½ months from now, that doubles your annualized return to 22.6%!

Scenario #2) Sun Microsystems trades lower than $3.82 and you are down on the position. If you wouldn’t mind owning the stock at the breakeven price, then this would not be that bad for you. You might decide to sell another call option on Sun Microsystems when the option expires in January if the stock is at or under $3.82.

Scenario #3) “The wild card”: Options are exercised for one of two reasons. They can be exercised because someone who bought the same option that you have sold wants to buy your stock at the strike price (in this case $4.00) at any time before, or upon expiration day. But options can also be automatically exercised (by the O.C.C. or Options Clearing Corporation) if they are 25 cents or more, in-the-money.

What does that mean? A call option is in-the-money when the stock is above the strike price. So if SUNW is over $4.00, it is in-the-money. So if SUNW is at $4.25 or higher, the O.C.C. will automatically call SUNW away from you at $4.00 if nobody has exercised their SUNW January 4.00 call that they own in order to buy the stock at $4.00.

This means that there is a chance that SUNW doesn’t get called away from you throughout the entire time that you have this position open, and if the stock is between your break even price of $3.82 and $4.24, your option contract may just expire worthless, and you can still own SUNW with an additional profit!

For instance, if SUNW was at $4.18 on expiration day, and you sell the stock at $4.18 on the following Monday, then you have made a profit of 8.94% which is 22.6% annualized, which is a heck of a lot better than 5% on treasuries isn’t it? As a matter of fact, that’s better than one can expect from the stock market on an average year.

Check the table below to guide you in your calculations when deciding which stocks to use for this strategy. Remember, you are only trying to find something that will return you much more than treasuries, and you should prefer to get called away from the stock.