Turning Crisis Into Income
Last week, I explained how investors can generate high income by selling covered call options. I showed how selling a call option against a stock position you already own can effectively multiply its dividend yield several times over.
That caused a reader to ask if the same technique can be used with stocks that pay no dividend. Not only can you do that, but in some cases it will produce an annualized return that is far greater than what you can get from a stock that pays a high dividend.
The reason is that call options are valued based on expected future price volatility, not dividend income. Generally speaking, most growth stocks pay very little or no dividends. That’s because those companies are reinvesting their excess cash flow into the growth of the business.
In my previous article, I used International Business Machines (NYSE: IBM) as an example. IBM is a mature company that generates more cash flow than it can reinvest for growth. For that reason, it pays a relatively high dividend yield of 4.8%.
For the very same reason, IBM is perceived as having limited future growth potential. A call option expiring in three months at IBM’s current share price will fetch an option premium of about 4%. On an annualized basis, that equates to an options premium yield of 16%.
That’s pretty good, but you can do a lot better. The key to maximizing the option premium yield is to focus on stocks that are considerably more volatile.
Last week, distribution of the COVID-19 vaccine produced by Johnson & Johnson (NYSE: JNJ) was temporarily suspended due to health concerns. That crisis triggered a ripple effect that caused call option premiums to spike for several of its competitors.
One of those competitors is Novavax (NSDQ: NVAX). I first wrote about Novavax last May after its share price jumped more than 900% in less than six months. At that time, it was trading below $45.
I recommended buying both a call and a put option on NVAX. I reasoned that its share price would “move sharply one way or the other” in the months to come.
Two months later, NVAX had soared above $110 for a gain of more than 500% on my recommended trade. Opportunities like that don’t come around very often. I was happy to book the gain and be done with it.
During the fourth quarter of 2020, NVAX traded in a relatively narrow range. But then it shot above $300 two months ago when its COVID-19 vaccine was approved for distribution in Europe and Asia.
Since then, NVAX has gradually receded below $180 until last week’s news about the JNJ vaccine. In one day, NVAX jumped more than 10%. That’s the perfect time to sell a covered call option.
While NVAX was trading near $193, the call option that expires on July 16 at the $200 strike price could be sold for $40. That equates to an options premium yield of 20.7% over three months. On an annualized basis, that works out to better than 82%.
Doing it Right
You may be wondering why someone would be willing to pay you so much money for the right to buy your shares of NVAX. The reason is “implied volatility.” Implied volatility is a mathematical measure of the degree to which a stock is expected to deviate from its present value.
In this case, Novavax makes something that is very high in demand at the moment. At the same time, one of its biggest competitors just dropped out of the race, at least for a while. For that reason, its share price could surge higher if JNJ is not able to get its vaccine back in distribution.
If NVAX rises above $200 within the next three months, then the options trade described above would be “in-the-money.” In this example, the maximum profit on the trade would be the $20 options premium plus the $7 share price appreciation.
If NVAX does not rise above $200 by expiration then this trade would remain “out-of-the-money.” In that case, the option would expire worthless and the stock would not be called away. You still get to keep the $20 options premium, and another call option could be sold against the very same shares of stock.
It’s not complicated, but most investors don’t have the time to learn how to do it right. However, that’s not a problem since I happen to work with one of the best in the business when it comes to covered call writing.
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