Using options to trade CVS Health: Portfolio manager

Key Concepts

• Covered Call: An options strategy where an investor sells a call option on a stock they already own. This gives the buyer the right, but not the obligation, to purchase the stock at a specified price (strike price) before the option expires.
• Premium Income: The cash received by the seller of a call option from the buyer. This income reduces the cost of owning the underlying stock.
• Cost Basis: The original price paid for an asset, adjusted for any additional costs or income. Selling covered calls can effectively lower the cost basis of the stock.
• Strike Price: The predetermined price at which the option buyer can purchase the underlying stock.
• Expiration Date: The date on which the option contract becomes void.
• Volatility: A measure of the degree of variation of a trading price series over time. Higher volatility generally leads to higher option premiums.
• Defensive Quality: Refers to stocks of companies that tend to perform relatively well during economic downturns, often characterized by stable demand for their products or services.
• Free Cash Flow: The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
• Dividend Yield: The annual dividend payment per share divided by the stock's current share price, expressed as a percentage.
• Monetizing Volatility: Generating income by selling options, particularly in volatile markets, to profit from the premium received.
• Dispersion of Volatility: The difference in volatility levels between individual stocks and broader market indices.

Covered Calls: A Strategy for Income Generation in Expensive Markets

This discussion focuses on the covered call strategy as a method to generate income, particularly in the current market environment characterized by high valuations and significant volatility. Barry Martin, lead portfolio manager at Shelton Equity Income Strategies, explains how selling covered calls can reduce the cost of owning stocks and enhance returns.

Main Topics and Key Points

• Covered Call Strategy Explained:

  • Selling a covered call involves selling an option that grants another investor the right to buy a stock you own at a fixed price.
  • The primary benefit is receiving premium income, which lowers the effective cost of owning the stock.
  • This strategy is particularly attractive in expensive markets and during periods of high volatility.
  • The goal is to "monetize the volatility" underlying a stock position by generating additional cash returns.

• Suitability of General Motors (GM) for Covered Calls:

  • GM is presented as a suitable candidate due to a stable auto sector, its defensive qualities, its ability to generate free cash flow, and its recent strong performance, trading near all-time highs.
  • Example: Selling a December 75 call option on GM.
    • Premium: A buyer might pay $1.10 for the right to purchase GM at $75 per share by the third Friday of December.
    • Scenario 1 (GM below $75): If GM's stock price remains below $75 by expiration, the seller keeps the $1.10 premium, effectively reducing their cost basis or adding to their proceeds. This premium can be reinvested.
    • Scenario 2 (GM at or above $75): If GM reaches $75, the seller has the choice to let the stock be sold at the strike price or buy back the option.
    • Potential Return: With GM trading around $70, selling the December 75 call offers approximately $5 of potential upside in the stock price plus the $1.10 premium, totaling $6.10. This represents an estimated 8-9% return, calculated as ($6.10 / $70).

• CVS Health as a Defensive Play:

  • CVS is considered a more defensive stock, already paying a substantial dividend (over 3%).
  • Combining covered call income with the dividend can create a significant total return.
  • Example: Selling a November 87 call option on CVS.
    • Premium: For a strike price of $87, a buyer might pay $1.41, with the option expiring in 25 days (November).
    • Total Return: Adding the $1.41 premium to the 3.5% dividend yield could result in a total return of 7-9% or more on a defensive name.
    • Consideration: The upside potential might be limited due to the stock's performance and the strike price chosen.

• Newmont Mining: A Contrarian Play Leveraging Volatility:

  • Newmont is presented as a contrarian play, given recent volatility in gold stocks, even though gold has come off its peaks.
  • The strategy is to capitalize on the volatility within the underlying equity.
  • Past Example: Previously, selling $80 calls on Newmont resulted in the stock going "deep into the money" (above $80) and then coming back down, effectively dampening volatility for the investor.
  • Example: Selling shorter-dated November 85 calls.
    • Premium: These calls are currently paying approximately $1.44.
    • Potential Return: This offers about 8% upside from the premium, which can be added to the stock's dividend yield for an attractive play.
  • Mitigating Risk: The discussion touches upon potential merger or acquisition activity (e.g., interest in Barrick Mining or Nevada operations). If such news negatively impacts the stock price, the premium income from covered calls can help mitigate losses.

Key Arguments and Perspectives

• Market Conditions Favor Covered Calls: The current market, described as "expensive" and "volatile," makes covered calls an attractive strategy for generating income and reducing the cost of ownership.
• Active Management in Individual Stocks: The speaker advocates for actively selling calls on individual equities rather than broad indices. This is because individual stock volatility is often less depressed than index volatility, offering better premium opportunities.
• Dispersion of Volatility: There's a noticeable difference in volatility between single stocks and indices. Individual stock options still offer attractive premiums, unlike S&P 500 calls, which are perceived as more depressed due to widespread selling.
• Downside of Covered Calls: The primary downside is the capping of upside potential if the underlying stock experiences dramatic appreciation. The investor would be "called out" of their position at the strike price.
• Upside of Covered Calls: The strategy provides a cushion against minor price declines due to the premium received.

Step-by-Step Process (Implied)

1. Identify Suitable Stocks: Look for stocks with defensive qualities, free cash flow generation, and recent positive performance, or those experiencing significant volatility.
2. Select Option Contract: Choose a call option with a strike price above the current stock price (out-of-the-money) and an expiration date that aligns with the investor's outlook and desired income frequency.
3. Sell the Call Option: Execute the trade to sell the call option, receiving the premium.
4. Monitor the Stock and Option:
   • If the stock price stays below the strike price by expiration, keep the premium and consider selling another covered call.
   • If the stock price reaches or exceeds the strike price, decide whether to let the stock be sold at the strike price or buy back the option.

Data, Research Findings, or Statistics

• GM Example: A $1.10 premium on a $75 strike price for GM, with the stock at $70, offers an 8-9% return ($6.10 / $70).
• CVS Example: A 3.5% dividend yield combined with a potential 4-6% from covered calls could yield 7-9% total return. A $1.41 premium on a November 87 call for CVS.
• Newmont Example: A $1.44 premium on a November 85 call for Newmont offers about 8% upside from the premium alone.

Notable Quotes or Significant Statements

• "So what we're doing is generating additional cash returns by monetizing the volatility underlying position." - Barry Martin
• "So you get the $5 in upside plus someone's going to give you a $110. So really, as you mentioned before, you're either reducing your cost basis by A110 or you're adding to the proceeds." - Andrew (host, paraphrasing the benefit)
• "So I think individual calls are still some some somewhere where it's not depressed especially now — especially in names like General Motors, CVS and Newmont Mining but in in S&P calls it's a little different." - Barry Martin

Technical Terms, Concepts, or Specialized Vocabulary

• Covered Call: (As defined in Key Concepts)
• Premium: The price paid by the buyer of an option to the seller.
• Strike Price: The price at which the underlying asset can be bought or sold.
• Expiration: The date on which an option contract ceases to exist.
• In the Money: An option is "in the money" if its strike price is favorable relative to the current market price of the underlying asset. For a call option, this means the stock price is above the strike price.
• Out of the Money: An option is "out of the money" if its strike price is unfavorable relative to the current market price of the underlying asset. For a call option, this means the stock price is below the strike price.
• Monetizing Volatility: Generating income by selling options, especially in volatile markets, to profit from the premium received.

Logical Connections Between Different Sections and Ideas

The discussion flows logically from a general introduction to the covered call strategy to specific examples of its application in different market scenarios and on various stocks. The host sets the stage by highlighting the relevance of covered calls in expensive markets. Barry Martin then elaborates on the strategy's mechanics and benefits, using GM as a primary example to illustrate the potential returns and decision-making process. He then extends the concept to CVS, emphasizing its defensive attributes and dividend yield, and finally to Newmont, showcasing how to leverage volatility in a more cyclical sector. The conversation concludes with a broader perspective on the market impact of covered call popularity and a distinction between individual stock and index option strategies.

Synthesis/Conclusion

The covered call strategy offers a compelling method for investors to generate income and reduce their cost basis, particularly in the current market characterized by high valuations and volatility. By selling call options on stocks they own, investors can profit from premium income, which can significantly enhance overall returns, especially when combined with dividends. While the strategy caps upside potential, it provides a cushion against minor price declines and allows investors to actively manage their portfolios by "monetizing volatility." The discussion highlights that individual stock options currently offer more attractive premiums compared to index options due to a dispersion in volatility. General Motors, CVS Health, and Newmont Mining are presented as examples of stocks suitable for this strategy, each with unique characteristics that make them amenable to covered call writing.