Generally with a long-term play, our goal is to find undervalued companies that we belive will go up in value over time with the intention of selling shorter-term calls against it while we wait. The same can be done on put spreads for companies we find overvalued and it is good to have some balance as major market moves can take everything down or up, regardless of merit.
I generally prefer to look for things that are not too volatile, as it makes it more difficult to manage the contracts you sell. Also, in a prolonged or sharp down-trend, the losses on the longs can exceed what you are able to cover and it makes it difficult to stay with the position by rolling it down. Of course that is true for stocks as well, only with options there is the added time pressure, even in the longer plays. Still, it’s a very good strategy for flat to up markets and one that keeps you in the premium selling buisness, as opposed to the premium buying business.
I’ll be adding to this list as time goes on but if you take positions like these it is best to scale in over time so that you can make adjustments. When you are fully covered (which means for that particular month you are nervous the stock will fall or at least not meet the target) then it is very important to have stops on the calls you sell. As a rule of thumb, stopping out 25% of the callers when they gain 25% is a good idea and another 25% at 50% at which point it usually pays to roll them up to full coverage at a higher strike again. This is, of course, if you belive the upside move is sustainable and that your original target premise for the month was too low.
The logic of this is that you sell 20 covers for $1 so that’s $2,000 of coverage against your long call. At $1.25, you spend $625 to buy back 1/4 but the value of the remaining 15 covers is still $1,875. Presumably your long calls are gaining as well at that point. Should the stock fall – even if you re-cover at .75, the total coverage sold will have only gone down to $1,875 less the extra $125 paid to stop out the callers.
If you stop out your second 1/4 of the callers when they are up 50%, that will cost $250 plus the $125 from the first 1/4 plus, of course, the $1,000 the callers gave you to begin with. You would still have $675 of their money in your pocket but the remaining 10 calls would be worth $1,500. Hopefully your long position is keeping up but the cash management of these plays is very important. Very often, 10 calls at $1,500 can be rolled to the next higher strike of 20 calls for about $1,500. This is a big decision as you would be committing to a higher target but the advantage is you are putting the callers, who are probably mainly intrinisc value that you already owe, into premiums that you may never have to pay off.
When you have a lot of time against your caller, upside moves are rarely a problem unless they are very sharp and as long as you don’t let the callers get away from you. When moves go against you, we have simpler rules like: If there are more than 2 weeks left to expiration and your caller has dropped 50% or more in value, you should strongly consider taking them out if you remain bullish on the overall position. Even if you are bearish, once a caller gives up 70% of his value, there is going to be little to be gained by keeping it as it is very likely time to consider rolling down the position (if you feel it is the end of the down move) or at least selling lower strike calls against a continued downturn.
Some of the long ideas I currently like are (date added in brackets):
*9/21 Note – it is very tricky to cover leaps in a market that has sunk so low. Should the week continue to be strong, it may be good to consider an entry into the leaps as simply a long-term buy with little or no cover, patiently waiting for a recovery, setting normal stops on the long end.
ABX (9/21 – $35.10): I loved them early in the week when they were at $28, they are a tougher call at $35 but ABX is a good, solid grower and it’s a nice way to play gold, which "only" averaged about $750 last year so revisiting that level is no reason to drop ABX, who claim 125M ounces of gold reserves ($97Bn) against a $31Bn market cap. Energy costs have been impacting revenues but they still made $1.1Bn on $6.3Bn in sales last year. I don’t know if this stock is a moon shot but 2010 $30s are $9.80 and Oct $37.50s can be sold for $1.45, that’s not a bad way to start a spread.
BA (9/21 – $59.76): This has been one of my favorite values since $80 so be warned! They have a strike and the global economy may be failing yet the estimates for their 2009 revenues have gone down just .10 in the past 3 months (2008 was knicked down 8%) to $6.88, a whopping 30% over fiscal 2007s total of $5.26 per share. Even if 1/2 of the orders for Dreamliners were cancelled tomorrow, the company would still be backlogged to the end of 2010. BA currently has 3.600 planes on order valued at $263Bn and in last year’s record year the company was able to put $66Bn out the door but 40% of that was non commercial aricraft (BA is very diversified). At that pace, even if the company was 100% aircraft, it would take 4 full years to fill the orders. As dreamliners go out the door, sales are expected to hit about $72Bn in FY ’09 and last year (ending June) the company made $4Bn – not bad with a current market cap of just $44Bn. On something this beaten down, I favor just picking up the 2010 $65 calls at $8.15 and waiting patiently for a nice move up. If it doesn’t come, then a $4 roll down to the 2010 $55s puts you in a position to sell something like the Oct $65s for $1 with little worry about the upside. 12 $1 sales and the rolled long position would have very little basis remaining.
CAT (9/27 – $64.13): A good one if housing ever recovers. To be very clear, CAT will be in deep trouble if we slip into a global recession but they are already 25% off their highs and 2010 $55s closed at $14.82 not a big move up from $13.50 in Wednesday when the stock was down below $62 and the Nov $67.50 calls can already be sold for $3, a very nice 60-day return. The 50 dma is down at $68 and has crossed well below the 200 dma at $73 so they should get stuck in that range. This would be a momentum play on the Dow to start but the calls have a nice premium for a monthly sell as even selling 1/2 covers for 10 months at $3 each nets $15 per long share so it’s a good risk/reward.
HTX (9/21 – $18.09): This one is speculative but I’ve been watching them for quite a while. The company’s apparent revenues are all over the place due to asset sales last year and this year but, according to the company: "net profit excluding the profits on property revaluation and disposal of investments and other extraordinary items for both periods (1st half ’08) improved by 199%." They also derive profits from HUSKF, which has driven a lot of growth on high oil prices. This is just a good, old fashioned value play but they will continue to report lower earnings to comps that include discarded divisions. 2010 $15s are $4.88 and if you set a goal to collect .40 per month, then perhaps selling 1/3 of the Oct $17.50s at $1.20 could be considered a start.
IBM (9/21 – $118.85): They used to say "no one ever got fired for choosing IBM" and I’m not really considering the merits of the stock here but you can pick up 2010 $110s for $20.75 and sell Oct $120s for $4.30 – that’s a pretty good spread as you can always roll up the longs to a larger position and the Jan $125s are $5.10 so looking ahead to that possible roll isn’t so bad, even if it does take off.
INTC (9/21 – $19.23): STX is optimistic about SSD sales (new for INTC, who will compete), AMD is not much competition and AAPL now has Intel inside. And then there is much delayed WiMax, which may pay off one day. INTC has great projected growth, over 10% for the next 2 years and they beat last Q by 12% yet they are down 20% for their troubles since then. 2010 $20s are $3.05 but it’s not much fun to sell calls against them when you are out of the money. It’s more like a long-term gamble that things aren’t as bad as they seem. The 50 and 200 dma are about $22 so THAT is where it becomes a good idea to sell some $22.50s.
MSFT (9/21 – $25.16): There is a concern that their stranglehold on desktops will erode over time as Google’s Android and other web-based operating systems take over but there are long-term security issues still to address and corporate computing is a long way from giving up their SQL databases. MSFT is simply a juggernaut that still grows earnings at around 15% a year desptie total misses like Zune. 2011 $25s are $5.62 and Oct $27s are already fetching .55. Even if you wait and end up selling the $27 callers for .30, that’s still not a bad month considering you have 26 more months to sell between now and the expiration of the leaps.
SNE (9/27 – $32.41): They came of a huge downturn I noted on the 18th when GS cut them to neutral from buy. At the time th estockwas at $33 and it’s back near there now. Sony has a much lower p/e than AAPL (13.5 for next year vs 21.3 for AAPL) but is an equally broad market player with the added advantage of having $10Bn in cash, $4Bn in short-term investments and $43Bn in long-term investments – not bad for a $33Bn market cap. Don’t forget they service their debt at Japanese bank rates too, so they can handle a downturn pretty well. This company is down near 1/2 price from last year’s highs and back below the 2005 mid-range of $37. The have lost the console wars to Nintendo, no doubt about that, but the 2010 $35s are just $4.85 and the Oct $35s are already selling for .53 so this is another play I like as a momentum play on a bailout package, hopefully getting $1 for the $35s but settling for $1 for the Nov. $35s (now $1.20) if it heads the wrong way.