One Good Idea: Write covered call options on energy stocks

This strategy puts money in your pocket by cashing in on high options premiums

Dianne Maley
Globe Investor Magazine online, October 28, 2008

Source: Richard Croft, president, Croft Financial Group, and Ross Clark, technical analyst, ChartWorks.

The Idea: Buy senior energy stocks and write covered call options on them. That means giving another investor the option of buying your shares at a set price on a particular date in return for an upfront payment, known as the option premium. In normal times, writing covered calls wouldn't be a particularly good idea because you'd be capping your potential capital gain in exchange for a few dollars in your pocket. But big swings in stock markets are pushing option premiums to new highs measured by the Chicago Board Options Exchange Volatility Index, or VIX, which reflects the market's expectation of volatility in the coming month. A high VIX number corresponds to a more volatile market and, therefore, more costly options.

On Wednesday, the VIX soared to a high of more than 80 at one point, up from 20 in early September, pointing to option premiums of 17.5 per cent, says Mr. Croft. If you had bought a stock at $100 and given someone the option to buy it at the same price over the next six months, you'd have pocketed $17.50 a share.

Mr. Croft offers this real life example in a paper posted on the Montreal Exchange Web site. With the collapse in the price of crude oil, Petro-Canada shares were trading at $25.74 on October 18. Calls on the shares expiring on Jan. 27, 2009, were trading at $3.25. So the sale of the call option would reduce the cost of buying Petro-Canada shares to $22.51, less than the stock's 52-week low and a price not seen since 2003.

Looking ahead, Mr. Croft calculates that the price of oil has likely hit bottom and is due for a bounce to the $80 or $90 (U.S.) a barrel range. Petro-Canada stock would rise in step but it would not likely surpass $30 a share, he estimated. This strategy makes sense only if you expect the stock price to be fairly stable. If it doubles, you will have to be content with your premium. If it slips and the holder decides not to exercise the option, you are free to write another option, Mr. Croft points out.

The strategy can also be useful for income investors who have a portfolio of senior stocks they do not want to sell at current, low prices but would be willing to part with if the price rose substantially. It also gives the investors some immediate income, he notes. "That's why writing options today is so valuable."

Mr. Clark, whose ChartWorks is published by Institutional Advisors, also pointed to opportunities last week to write covered call options on energy stocks. With option premiums at or near record highs, the strategy allows investors to participate in some of the "upside action" in the stock, pocket a premium and get some downside protection to boot, Mr. Clark writes in his Oct. 20 bulletin. Why energy stocks? Because they have fallen too far and are due for a bounce over the next few months, he writes. He notes oil has been triggering daily "capitulation alerts," which no doubt flashed more urgently last Wednesday, when the oil price plunged nearly 7 per cent.

The Payoff: Money in your pocket now, regardless of what the stock price does. If it falls and the option holder decides not to exercise, you still have your stock - and you can write another option.

The Big Risk: The main risk is that the price tumbles and you lose a bundle of money - minus your option premium.

Why listen to Richard Croft and Ross Clark? Richard Croft has been devising and writing about options strategies for 30 years, most recently as a portfolio manager of the investment company he founded in 1992. Technical analyst Ross Clark is renowned for calling major turns in commodity markets, including the top in the oil market last July.

- Special to the Globe and Mail