There is a way for investors to enhance their income from stocks. It is called “option writing,” and it’s about knowing the how and why.
The most common mistake investors make is buying a stock without an objective. When I ask someone why he or she bought a particular stock, the common answer is that they bought it because they “hope” it will go up. OK, but up to what price? They don’t know. So I ask, well, for how long will you be holding the stock? The answer is almost always “until it goes up.” Remember that I am talking with an adult, and yet here is an investor who doesn’t know how to define “up”—and has no relationship to time. Heck, I have seen “professionals” buy common stocks because they felt the price reflected great value. However, when I asked them at what price they would sell—when the stock was no longer at bargain value—they had no idea. Some will say “a higher price” but with no time factor whatsoever.
In this article I aim to tell you what you need to know before you buy shares of stock and why to sell them. The No. 1 reason to sell is because the stock price has reached your objective. You NEVER (and yes, I am shouting!) buy stock without a price objective. Can the objective change? Sure, if the circumstances change due to a particular factor. Every stock I buy is bought with a price objective. I love to buy stocks that pay a dividend. Why? Well, because that’s my pay for being a shareholder. It’s my share of the profits. There are stocks that pay nothing to shareholders but reward the executives and the board of directors, who suck off the cash while their shareholders get nothing. In fact, the more cash they hoard, the easier it is for them to reach their bonus levels and for them to get more cash. They can afford what you can’t because they are getting paid and you are getting nothing.
So, how can you be a successful investor? First, even you if bought a stock because you like the products of companies such as Apple (AAPL), Google (GOOG) or Darling International (DAR)—even though they don’t pay you anything—you need to set a price objective that you expect to see within a certain period of time. Let’s say that you bought Apple today at $332.44 (closing price). Well, you can sell the Oct. 360 call for $10.40. And you get this money right away. If you sell the stock in four months for $360, you pick up an additional $27.56. So you grossed $37.96 on you investment of $332.44. That’s a return of 11.42 percent in four months, which annualizes out to 34.26 percent. When you do something there’s got to be a reason why you do it. Set some sort of a goal so that you know you’ve obtained it, otherwise, you don’t know what the heck you’re doing. I’ve found that to be the case with 99 percent of people. If a stock hits your goal, you should sell it. The mistake people make is thinking the stock could go higher. Well, that’s true—but it could also go lower. People hold on to Apple stock, for example, even though it doesn’t pay any dividends. To get $330 to $400 per share, the stories about it would have to be terrific. And yet people hold on even though it’s paying zero. One of these days the profit margin will come down, analysts will say “get out” and the collapse will begin.
Frankly, I don’t like to buy any stock that doesn’t pay me too. So, let’s look at Campbell Soup. The stock currently pays a dividend of 3.4 percent. So, today we paid $34 and can sell the Jan. 2012 37 call for 50¢. The current dividend is 29¢ quarterly. So, I will get three quarterly dividends of 29¢ each as well as the 50¢ for selling the option. If the stock gets called away (sold by me at $37), I pick up $3 a share as well as $1.37 in dividends—and the option premium for a total of $4.37 on a $34 investment, for a total gross return of 12.85 percent in seven months. That’s an annual return of 22.03 percent a year. We aren’t talking about excitement. We are talking about Campbell Soup. Those returns are “Mm Mm Good.” I own Campbell Soup stock and sell options on it.
In my next article, I will tell you how I handle a stock if it’s not called away. “Called away” is a term used to describe the elimination of a contract due to the obligation of delivery. This occurs if an option is exercised, if a redeemable bond is called before maturity or if a short position held in a security requires delivery.
Warren Kaplan © 2011
Warren Kaplan has been writing options for 50 years. He has been a stockbroker, investment banker and brokerage owner. He currently owns and operates Kaplan Asset Management, a provider of financial assistance for small to middle market businesses. He has more than a half-century of experience in dealing with financial markets, giving guidance and consulting with management, and assisting in the development of business strategies and solutions. The Company has assisted and consulted many successful companies, such as Natures Bounty (NBTY) and Action Products International (APII), helping them to go public and trade on the NASDAQ stock exchange. His philosophy is to “do something with the profits.” “If you make $100 in the stock market, take 50 percent and invest it back into the market. Then, take the other 50 percent and buy yourself something.” Kaplan is currently traveling to the North Pole.
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