Example of Buying Into Weakness – Investment Rule #1

Gen Y Finance Guy Financial Markets, Investing, Options 22 Comments

“Dude, suckin’ at something is the first step to being sorta good at something.” -Jake, “Adventure Time”


A few days ago I wrote a post laying the foundation for my 10 rules for investing. In rule #1 we discussed what it means to buy into weakness. After some good dialogue with you guys in the comments of that post, it dawned on me to include a real example of what it actually looks like to buy into weakness. It was a comment by Mr. Maroon that helped spark the idea when she said:

Enter Mrs. Maroon

When we first started aggressively trying to save money for investments and actively watching our balances, we agreed that the very best approach was to use total market index funds from Vanguard. We don’t have the time, education, or desire to do the research required for much of anything else. And then, oil prices plummeted. For several weeks we tossed around topics about how we should buy into oil since it was so low right now. Eventually the idea took hold, and we bought a chunk of the energy ETF from Vanguard. But we are still very much newbies to the investing world. I’m eager to learn more in the rest of the series!

This comment was really the highlight of my day, because I knew by her response that she fully understood what buying into weakness meant. As Mrs. Maroon pointed out, oil and most companies in the entire sector have gotten hammered over the past 6-months. Below is a chart of the ETF OIH that is made up of a bunch of companies in the oil services sector. And for those not familiar with an ETF, it is basically like a mutual fund that trades like a stock (with far lower fees, and greater liquidity). I am not a technical analysis guru, I only present this chart because I think the picture speaks for itself when I refer to weakness.

OIH_2_12_15

In the chart above you can easily see that the high over the last 12 months was at $58.01 and the low put in January was $31.63 (that’s $26.38 lower than the high in July of last year). I don’t know about you, but a decline of 45% in price sure as hell qualifies as weakness in my book.

And let me say this loud and clear. If you are patient these kinds of opportunities come more often than you would think. But remember that this usually means buying this when everyone else is telling you to stay away.

So how do you take advantage of this opportunity?

The most obvious option is to just go and buy the stock outright. These days almost everyone has an account with online access to buy and sell stocks (and maybe options???). I wrote this post after the market closed on 2/12/15, but I did in fact buy OIH for $35.56/share. In total I only purchased 100 shares. Now for many of you reading this, that is where you stop. You buy the stock, sit back and collect the dividend (which is currently around a 2.4% yield) and hope it goes up in value. NOT ME, AND HOPEFULLY SOON NOT YOU EITHER!

The Covered Call

The covered what???

The covered call is a strategy whereby you buy 100 shares of stock and you sell a call (an option) against your stock…thus you are covered. In English please…

Ok, let’s start with the definition of a call option:

  • From the buyer’s perspective, a call option is a contract that gives the buyer the option, but not the obligation to buy shares of a certain stock at a pre-defined price by a set date in the future.
  • From the seller’s perspective, a call option is a contract that gives the seller the obligation to sell shares of a certain stock at a pre-defined price by a set date in the future.

By selling a call against our stock position we are obligating ourselves to sell it at a certain price (known as the strike price) and by a certain date (known as expiration). In return for that obligation we get to collect a payment from the buyer (known as a premium).

So let’s take a look at what I did today and walk through it:

Bought: 100 shares of OIH @ $35.38 for a total of $3,538

Sold: 1 call option at the $35 strike that expires 1/15/16 for a premium of $4.38 or a total of $438.

What did I agree to do with this position and how much money can I make?

By selling the call at $35 I have agreed to sell my stock at $35 regardless of the price between now and 1/15/16. Even if it goes to $100, I have to sell it for $35. In return for giving up the upside I was able to collect $4.38/share or $438 total (or about 12.4% of the stock price).

Let me point out that most options expire worthless. This means that there is a good chance that you will get to keep both your stock and the premium you collected and do it again once expiration rolls around. You are effectively buying the stock at less than the market price.

Effective price = $35.38 (actual purchase price) minus $4.38 (premium collected) = $31/share

Max profit = $35 (obligated sales price) minus $31 (effective price) = $4/share or $400 for 100 shares (that is a 12.9% return on your $31/share effective price, not counting dividends)

I know it sounds too easy and too good to be true. But this is a legit strategy. However, it does have its trade-off, you are giving up unlimited upside and capping your max profit to the premium you received from selling the call.

What if the stock declines in price?

What is great about this strategy is that you now have downside protection built-in. Because your break-even is now at $31/share (not including dividends). You are effectively getting paid to take risk. And look at it this way, it doesn’t even make sense for the buyer of the call option to exercise their option (forcing you to sell your stock to them) until the stock is trading at least at their break-even of $39.38 (their effective price $35 + $4.38).

No matter what happens you get to keep the premium you collected. The best case scenario is the stock stays exactly where you bought it and the call expires worthless and you keep doing this over and over again. I have had stocks where my cost basis actually went really close to zero between selling calls and collecting the dividend.

Bring on the questions

I know that was a lot, especially if this was your first introduction to options and in particular the covered call strategy which will be 1 of 2 strategies that we talk about over the next 9 posts in the series of my 10 investment rules.

So ask away in the comments section below.

– Gen Y Finance Guy

Comments 22

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    BeSmartRich,

    This is a strategy that I have been using for years. And be rest assured that everything I blog about is either things I do, have done, or are currently trying.

    I think if there is one “advanced strategy” that everyone should know and use, it would be the covered call. Like I mentioned in the post, you do give up your right to unlimited upside, however you are still locking in a very respectable return from the premium you collect.

    Think to yourself how many stocks blow threw the roof. And also for capping your upside in my example above of 12.9%, I also have given my self some downside protection.

    By the way, this is a real investment that I walked through in the post. And I have some stocks that I have been able to do this over and over again. Also you don’t have to go as far out as a year to sell the premium, you can actually do it on a monthly basis if you want. Give you potential to collect more premium, but means you have to be more active.

    Please let me know if you have any questions.

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  4. I still haven’t taken the leap into any option strategy but if I was to start I would go with a covered call or writing puts to potentially buy into stocks I was looking into anyway. I think these two methods are probably the “safest” way for a beginner to get into derivatives. Thanks for sharing.
    DivHut recently posted…Regret Is My MotivatorMy Profile

    1. Post
      Author

      I always recommend the covered call or cash secured put as the first option strategy that anyone new to options starts with. I even go as far to say that if you can master these two strategies you can ignore the rest.

      As you have probably already figured out that the risk profile of a covered call or short put are identical. With the exception of option skew there really is no difference in selling the put or covered call when looking at the equivalent strike prices.

      Cheers!

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  5. Hello,

    Recently reading my way into finacial indipendence. I like the community.

    I question what you write here:

    .And look at it this way, it doesn’t even make sense for the buyer of the call option to exercise their option (forcing you to sell your stock to them) until the stock is trading at least at their break even of $39.38 (their effective price $35 + $4.38).

    The buyer of the option should in all cases where the stock trades above the strike of 35 exercise the option at the expiry day. This way, he can recover a part of the premium.

    Imagine that the stock is at 36. If he would exercisie the option, and get the stock at 35, he would make 1usd less loss…

    Or do I overlook something?

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      Hi Belegger,

      First I will state that 80% of all options go un-exercised. You are right that the buyer always has the “option” but not the “obligation” to exercise his option. But typically people that are buying options are betting that stocks are going to go up in value and increase at least as much as the premium they paid.

      Technically your are right that options that are at least $0.01 in the money are auto exercised unless you tell you broker otherwise. But in reality the option holder is actually better off just selling the option as expiration nears to close out his position. So lets say we are 1-day before expiration and the stock is trading for $36, this close to expiration the option will be made up of 99.9% intrinsic value, which means is should be trading for very close to $1. So instead of the option buyer taking the risk of exercising his option to take possession of the shares and seeing the shares drop, he/she in most cases would just sell the option for a $1 and thus lock in a loss of $3.38.

      And something I have not covered yet and this is a series that I will be building on over time. Is that as the seller of the option I/You would be inclined to close out your position in the same fashion, only you would realize the $3.38 as a gain. And then your stock in un-covered and you could do it all again.

      Make sense?

      Let me know if you have other questions. I have been trading options as a retail and professional trader for almost 10 years now. I absolutely love talking about this stuff.

      Cheers!

  6. Thx for the reply.

    I am happy to learn from a person with real life experience. Writing covered calls is an area I am exploring right now.

    I am an index investor, and the etfs that I buy have for the moment no options yet. There are some simiular indexs that I could buy (difference is acc vs paying a dividend). The options marekt is still new on euronext.

    The option premium for a 10 month call is today around 2,08 EUR pct. far off from the 12pct in your example. and I still need to cover the trading expenses.

    Any thought s on this?

    The link to the option market: https://derivatives.euronext.com/en/products/trackers-options/IWR-DAMS?Class_type=0&Class_symbol=IWR&Class_exchange=DAMS&ex=T&ps=999&md=09-2015%2C12-2015

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    My pleasure Belegger.

    The option premium or the price of the call is going to very by stock or ETF. There are several things that determine a stock:

    1) Time to expiration (we call this duration)
    2) Implied Volatility
    3) Price of the stock/ETF
    4) And interest rates

    The reason I tend to buy stocks into weakness and then sell calls against them is that price declines create fear that result in increased volatility that ultimately result in in creased premium.

    In your example you say that “The option premium for a 10 month call is today around 2,08 EUR”, what is the current price of the stock or ETF?

    Also you want to make sure you are selling the closest out of the money option to capture the most extrinsic value.

    Either was at 2,08 EUR, it should cover commissions. Remember that an option represents 100 shares so you have to multiply it by 100 to get the actual premium received, which in this case would be 208 EUR. You also need to have 100 shares for every call that you sell.

    Does that help?

    Cheers!

  8. The etf is now trading at 32,955 an option premium for 10 months is 2,08 for a strike of 32.

    If I do the math (32,955-2,08 is a asset price of 30,875, being called at 32) , this would mean a guaranteed return of 3,6pct? (excluding cost of writing the premium) This is a nice risk free return. The only thing ius that these ETFs are part of my monthly purchase plan for passive investing.

    Reading your info, I better wait till there is some stress in the market, causing the implied volatility to go up?

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      Yes you math looks like its in the ball park. Only thing I would change is going another strike out so that you are selling a out of the money option that is 100% extrinsic value.

      You also want to make sure the ETF has at least 1M shares traded on a daily basis, meaning it is a liquid underlying.

      Its okay if this is part of your monthly purchase plan. I don’t see the harm in that. What are you concerned about?

      You can wait, or lets say you have 500 shares. You could do a covered call on 100 shares now and then scale your way in as volatility pops.

      Cheers!

      1. Thx for the advice. Going out of the money feels better to me as well.

        Why I hestitate to do covered calls on my ETF in a monthly purchase plan: it would mean I just buy them back the mont after with my money received. This brings additional brokerage costs and maybe a higher to pay price for the ETF. This will reduce further the return.

        I will keep looking at this. It sounds like a nice thing to do, but rather in more volatile markets like during a market downturn. Is that a correct statement?

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  9. I’m honestly still lost… I do understand the concept. I was looking at tdameritrade account which is a margin account and I can buy options etc. I will definitely be doing further research into all this. Need maybe a how to guide for dummies or something.

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      Glad to have been able to put it on your radar. Oil has finally had a pretty nice bounce after brutal correction ($107 June 2014 down to $42 March 2015).

      The risk/reward looked good.

      Cheers!

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