Turning A Loser Into A Winner With Covered Calls
Today I want to discuss a technique that I used last year to turn a loss into a gain for one of the stocks in my portfolio. If the circumstances are right, this technique can add a few percentage points to the performance of your portfolio. But you need to understand the trade-offs you are making.
An Undervalued Natural Gas Play
As the bear market in the energy sector reasserted itself in the 1st half of 2017, there were many energy companies that I believed were deeply undervalued. While most of my recommendations performed well in the second half of the year, one of my portfolio holdings lagged.
EQT Corporation (NYSE: EQT) is a leading Marcellus driller with extensive holdings in the basin’s liquids-rich sweet spot. Following last year’s acquisition of Rice Energy, EQT became the largest natural gas driller in the U.S.
I thought EQT would be a significant beneficiary of the eventual recovery in natural gas prices. EQT was undervalued by most of my financial measures. It had a strong balance sheet with modest debt. In 2016, EQT’s production cost was a mere $0.23 per thousand standard cubic feet (Mcf) of natural gas.
I considered EQT to be the second best natural gas producer in the country, behind Cabot Oil and Gas (NYSE: COG). But I felt like EQT was more undervalued.
So, in early July 2017, I bought EQT at $60 a share. By year-end, EQT shares had fallen to $56.92. Yet I made money despite the 5% decline in share price. Here’s how.
Enter the Covered Call
Toward the end of July 2017, my EQT shares had risen to $64. I decided to lower my cost basis by writing a covered call against my position.
I sold a call option on my EQT shares at a strike price $70 a share, with an expiration to exercise this option in September. I received $1.18 a share for selling this option, which reduced my cost basis from $60 to $58.82 ($60.00 – $1.18). Each option represents 100 shares, so each option I sold netted $118.
The person buying the option is hoping EQT shares rise above $70 by the September expiration date. The risk to me is that if shares rose above $70, I would still only receive that price. For the duration of the option period, I have accepted a maximum potential gain of 19% on my shares (a cost basis of $58.82 and a sales price of $70).
Locking in a maximum potential gain of 19% for less than three months of ownership doesn’t seem too bad, but imagine if there had been a buyout offer of $100 a share. I would still only receive $70.00. That is the risk I am taking.
Wash, Rinse, Repeat
Instead, EQT shares declined. As the September expiration date approached, the share price fell to under $65. The option expired worthless. I got to keep the premium, and still had my shares.
I immediately sold another option. This time I received $2.63 a share for the option to buy my shares at $65, with an expiration in December. This lowered my overall cost basis to $56.18. In this case, I accepted a maximum gain of 16% (a cost basis of $56.18 and a sales price of $65.00).
Once more, the circumstances repeated. In December the share price fell to $55.00. The option expired worthless, so I sold another for $2.08. This one was for March expiration and a $62.50 strike price.
My overall cost basis is now down to $54.10, and I have once more accepted a maximum gain of 16% (a cost basis of $54.10 and a sales price of $62.50).
A 5% Loss Becomes a 5% Gain
Selling these covered call options has now reduced my overall cost basis by $5.90. This meant that even though EQT closed the year down 5% from my purchase price, I made a 5% profit while keeping a double-digit gain targeted.
Of course, my preference would have been to have those shares called away in September for a 19% gain. But given the decline in share price, I can’t really complain. In this case, covered calls turned a 5% loss into a 5% gain.
A Final Caveat
Selling covered calls is a strategy that can be repeated multiple times each year. But remember that you are accepting a maximum price for your shares — even if they rise far above the strike price. Thus, if you are extremely bullish on a company, you should probably forego the use of covered calls to lower your cost basis.
You can use covered calls to lower the cost basis of shares that are rising. Choosing a strike price that is 10-20% higher than the current price on an option that expires in two to three months is usually a safe bet if you wish to avoid having your shares called away. Just keep in mind that a higher strike price will net you a lower premium.
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