It’s a big day here at Rising Returns – today I sold my first option contract. I sold a call option on Flowers Foods (FLO). A typical contract is for 100 shares and since I own in excess of 100 shares of FLO, this is referred to as a covered call. Selling a covered call is a fairly typical way to experiment with options trading, due to the fact that as long as I hold my shares through the contract’s expiration date any obligation I may have on that date is already covered.
If you find yourself wondering what that all means, fear not. Here’s a high-level explanation.
As I mentioned above, sold a call option on shares of FLO that I already own. What is a call option? Well, I have agreed to sell shares in FLO to a counter party on an agreed upon date at an agreed upon price. In this case, I’ve agreed to sell 100 shares of FLO to a counter party on April 21, 2017 for $17.50 share. The counter party (the person who bought the contract) is under no obligation to exercise the contract. On April 21, 2017, if shares in FLO are trading below $17.50, the contract will most likely expire worthless and I will get to keep my shares. If FLO is trading above $17.50/share on that date, the contract will likely be exercised and I will sell my shares at $17.50 and the new owner will lock in an instant profit.
So, why would I do this? Simply put, I wanted to experiment. I’ve been interested in covered call trading for a long time and have never taken the plunge and sold a contract. So I decided to try it out. When anyone sells a call they collect an option premium, which must be paid by the counter party as the cost of buying the right to purchase shares at a given price on a given date. Here are the numbers for my specific situation:
100 shares of FLO at a cost basis of $15.26/share or $1,526 total.
Option premium collected: $.40/share, or $40, less $6.95 transaction fee and $.75/contract fee. Net option premium of $32.30.
If my shares are called away and I have to sell them at $17.50/share, I will make a profit of $2.24/share, or $224, plus the premium of $32.30, plus another $32 (a little more because of reinvestment, but $32 is close enough) in dividends collected between now and April for a total profit of $288.30 on an investment of $1,526 which equals an 18.89% return. I bought the shares in August 2015 so that roughly works out to a 28.6% annualized return. Someone check my math on that, but that’s not too bad.
If my shares are not called away, then I’ll still collect the $32.30 option premium and $32 in dividends and go on my way a happy man.
This strategy really works if you are planning to hold on to the shares throughout the contract period and would not have otherwise sold them. The downside is that you are giving up potential excess capital gains by putting your shares at risk of being called away, but if the strike price is fair then why not collect a little extra juice instead of just sitting on shares?
Have any of you experimented with this strategy? Obviously this trade was pretty small potatoes, but that’s ok. It’s a good way to gain some experience with the strategy.