With the market having stumbled earlier this month, you may be wondering how to hedge your portfolio and/or make some additional monthly income using covered calls — especially if you own some very expensive stocks.
Selling covered calls mean selling the right to someone to force you to sell them the stock at a given strike price on or before a given date. If that final closing price is higher than the strike price, you must execute the sell trade at that strike price. In exchange, you earn a premium for selling the calls, and it can be quite large in these expensive stocks.
Just remember, if the stock gets “called away” you could miss out on upside if the stock price passes the strike price by the amount of premium you received. You can always buy it back at any time, though. And if the stock stays flat or falls, then you’ve earned free money as income, or to hedge your downside.
This is one of the strategies I use in my stock and options advisory newsletter, The Liberty Portfolio, to generate extra income.
Covered Calls: Alphabet (GOOG)
GOOG stock has a five-year projected 25% annualized earnings-per-share growth. I award a 10% premium for its brand name, another 10% for free cash flow and 10% for net cash position. FY18 EPS of $48.58 and a $928 stock price (net of cash) means GOOGL stock is priced at only 19x earnings.
Even if GOOG only grows at 15% you are getting a bargain.
If you sell the 16 March $1,112.50 covered calls for $25, you pick up $2,500 just for selling the call. If GOOG stock is called away, you keep that bucket of cash. If GOOG stock closes on March 16 at or below $1,137.50, you still make money. If it closes below $1,112.50, you’ve earned a 2.2% return in just 24 days.
Covered Calls: Priceline (PCLN)
The Priceline Group Inc (NASDAQ:PCLN) remains the premier name in online travel. It’s a simple business to understand and with the economy back on track, I see good times ahead for PCLN stock.
Shares of Priceline sell for $1,880 per share, or $1,700 if you back out its net cash. (Thus PCLN trades at a P/E ratio of 23 on trailing twelve-month earnings. Analysts see annualized growth at 15%, and adding in a premium like I did with GOOG stock, having this growth stock trade at a PEG ratio of 1.4 or so is fine.
PCLN stock reports earnings next week. If it disappoints, it could tumble, so I would sell covered calls that are further out. The 20 April $1,880 covered calls sell for $95. That’s right — you drop $9,500 into your bank account with the trade. If PCLN closes above $1,880, the stock gets called away, but you don’t lose money unless you fail to buy back under $1,975.
If the stock does not get called away, and PCLN stock remains in your account, you’ve picked up that cold hard cash and/or hedged your position to the downside by 95 points, or 5.4%.
Covered Calls: Amazon (AMZN)
Amazon.com, Inc. (NASDAQ:AMZN) is a really tricky stock because it is just so hard to value it. My feeling is that if you own Amazon stock than you likely intend to hold it a very long time and don’t care about valuation. You have faith in the company to produce a profit if it needs to and in the meantime it makes tons of cash and takes over the world.
So, if you own Amazon, then you’re sitting around $1,486.79 per share. Maybe you want to grab some cash and hedge, maybe you are fine to buy AMZN stock back if it moves higher.
The 16 March $1,500 covered calls are selling for $34. In this case, you will generate $3,400 in cash right here and now. If the trade goes against you and Amazon rises, it has to go beyond $1,534 before you lose money.
Should the stock go down, you are hedged all the way down to $1,449. Not much in the world of this stock, but it’s something.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.