SINGLE STOCK POSITIONS / OPTIONS BASICS

What is an option?

An option is a contract to buy or sell a specific financial product known as the option’s underlying instrument or underlying interest.  For equity options, and for the purpose of explaining our strategy, assume the underlying instrument is a stock or similar product.  The contract establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.  The option contract also has a expiration date.

“A study conducted by the Chicago Mercantile Exchange over a period of three years (1997-1999), confirmed that an average of 76.5% of all options held to expiration in five markets expired worthless (out of the money).  Therefore, option sellers are able to take advantage of this tendency, while the option buyers lose approximately 80% of the time.” -”Options sellers vs. buyers: Who wins?” John F. Summa.  Futures: Mar 2003; 32, 4; ABI/INFORM Global pg. 52

The Definition of a Covered Call

Covered call writing is the sale (writing) of a call option against a stock currently held by an investor. Generally, one call option represents 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is “paid” to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.

Who Should Consider Covered Calls?

Any investor who is neutral to moderately bullish on a large equity position in his/her portfolio and is willing to limit his/her upside potential in exchange for some downside protection.

Any investor who is willing to generate income in exchange for assuming the obligation or risk of selling a particular stock at a specified price. Generally at a price considerably higher than where the stock is currently trading.

How to Use Covered Calls

Let’s say that 100 shares are currently held in an investors account. If the investor were to sell one call against these shares, he/she would be paid a premium for the obligation to sell the stock at a predetermined price (the strike price.) In addition to receiving the premium, the investor would also continue to receive the dividends (if any) as long as he/she still owns the stock.

The Downside

Like any investment, hedging a portfolio through covered call writing is carries risk. Upon writing covered calls against his/her shares, the investor is at risk of losing the stock if it rises above the agreed upon strike price. Remember… In exchange for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you will see in the following example, even though he/she has given up some of the upside potential there can still be a strong return on the investment.

A discussion of what you can expect to occur upon expiration of your call options (along with realistic graphical examples) follows on the next page.

Possible Outcomes upon Expiration of Your Call Options

When writing near-term, slightly out-of-the-money calls against a stock that you already own, there are really two possible outcomes when those options expire…

The stock price is trading at or above the option strike price:

In this case, the options will ordinarily be “exercised” (i.e. your stock is “called away” from you by the holder of those options at the strike price of the options). Your profit on the transaction will include the premium that you received for writing the options, plus the difference between the strike price of the option and your original purchase price of the stock. However, you will have given up the opportunity to participate in any additional profit possible from continued rise in the stock price above the strike price.

The stock price is trading below the option strike price:

At expiration call options in this scenario will ordinarily expire worthless to the option owner (who is unlikely to “call” the stock away from you for a higher price than it would cost to buy it on the open market.) Therefore, in addition to still owning the underlying shares of stock, you would also retain the premium that you received when you sold the call options. If the stock price has fallen since purchase, your loss has been cushioned by the income generated from the calls. Furthermore, you now have the opportunity continue to earn income by writing additional covered calls against the position!

Next we will take a graphical look at how selling calls can supplement a large equity position. You will see how potential market risk is reduced, and how the movement in the underlying shares will affect your profits!

The following graph illustrates how the profit/loss equation will look when a covered call is written against an investors existing shares (hedging the position). The option contract is represented in blue, and the stock is represented in red.

As you can see, there is a breakeven point around $62.50. But how is this arrived at?

Assume the stock was trading somewhere around $50 in this example when the investor wrote a call option contract against it for a premium of 2 ½. You can see that as long as the stock does not trade over $60 before expiration, the client is earning a profit (income) from his call option position. However, should the stock trade above $60 the shares are at risk of being called away. Should this happen, the investor retains the premium taken in from the sale of the call and takes in $60 per share of stock called away. He/she may now elect to simply repurchase the shares and write a new set of calls against the shares. Or the investor may simply use the profits to move onto another investment.

Notice though that the breakeven point is actually $62.50 rather than at $60 per share. This is because even though the strike price was $60 in our example, the investor took in $2.50 per share when the calls were written. This translates into the stock being effectively sold at $62.50 per share.

Obviously, if the stock does not reach $60 per share before expiration, the client has successfully hedged his position and generated $2.50 of income per share of stock owned. He/she is now free to write another set of calls for the coming month… Starting the income generating process again!

ASSET ALLOCATION

Asset allocation is the process of selecting a mix of asset classes through efficient allocation of capital to those assets by matching rates of return to a specified and quantifiable tolerance for risk. The asset allocation models we use in designing a client’s investment portfolio are diversified into at least four (4) different sectors of the market in order to minimize sector and industry risk. Each model consists of a different “target” asset allocation, comprised of different asset classes – spreading capital among a variety of investments as opposed to investing in just one – creating a more prudent approach to managing risk.

The investment mix for each client is uniquely designed to achieve the desired investment return for the client. However, the selected equities and fixed income vehicles in a client’s portfolio are typically diversified into many stocks and bonds that are common to all client accounts. This is the only common denominator; from that point the composition mix and quantity of stocks and bonds in any given client account is completely subjective.

Typical composition mix classifications:

Such allocation guidelines are a representation of a typical account composition but should not be construed as absolute. Ultimately, the exact composition makeup and allocation of securities are determined by the client’s investment parameters, which can compose a more detailed and/or complex structure.

The Company’s portfolio-managed accounts are designed to suit each client’s investment needs, accessing international debt and equity markets with a foundation of mostly no-load, institutional funds. In addition, the Company may also recommend, from time-to-time, using other investment vehicles to achieve the client’s desired investment objective; such as: derivatives, closed-end funds, equipment leasing, real estate, private placements and other publicly traded securities.

FIXED INCOME PORTFOLIO ALLOCATION

The Investment strategy for fixed income portfolios is designed to capitalize on opportunities available during the interest rate cycle. Bonds also provide added diversification for accounts requiring lower volatility and higher income. Lyons Wealth Management, LLC’s objective is to pay close attention to the spreads between government and corporate bonds and invest according to each client’s investment goals and risk tolerance. Credit risk is determined through objective fundamental analysis. Municipal bonds may be utilized in taxable accounts where they provide a higher tax advantaged yield.