April 6, 2021
By: Michael Oyster, Chief Investment Officer
Throughout Warren Buffett’s letters to investors, the word “compound” appears again and again. Oddly, his use of the word, which expresses an investment discipline, rarely attracts attention. Instead, investors tend to focus on Buffett’s outperformance or underperformance against broad equity benchmarks like the S&P 500.
The great investor story can excite the market mob, but to us, generally proves meaningless. In our view, what matters most is creating a compounding engine within one’s investment portfolio so that one’s wealth can grow.
Dividends can be a key source of a stock’s historical return. In fact, dividends and inflation can contribute substantially to stock returns over time. Many investors have found that they can achieve their goals by simply finding quality stocks that pay dividends.
It is within the framework of compounding returns that we view the use of options to generate income. We believe this view is not widely socialized because many investors simply see options incompletely, and perhaps even incorrectly. We prefer to use options as tools to achieve objectives for equities, indexes, and portfolios. We favor using options to power compounding engines for equity investments.
By selling covered calls, an investor can incrementally increase the amount of money received from owning a stock. The strategy is commenced with the full understanding that anyone who sells a call runs the risk of losing money by having to cover the short call or sell the stock.
The sale of cash-secured put options typically carries a similar risk. Anyone who sells a put runs the risk of losing money and having to cover the short put or buy the stock, perhaps at less–than–advantageous prices. To us, it is important to define the contours of the income-generation strategies because it helps to reinforce the opportunity that enables investors to use options in this way.
We like to talk about the sale of options as generating conditional dividends. In our view, the condition of the dividend is that an investor must be willing to buy stock or sell the stock, at the specified stock prices.
To us, a covered call strategy is elemental, and that makes it powerful. . Consider a $30 stock. With one month until the next options expiration, the stock’s owner sells the call option with a $35 strike price, which is priced at $2. The $2 option price reflects the market’s belief that the stock could move higher quite quickly. One month later, the stock ends at $33. The market was correct in terms of direction but not magnitude and the investor earned a profit of $5 ($3 on stock price appreciation and $2 income from selling the call option that expired out of the money, i.e., stock price below strike price) or 17%.
Of course, this illustration is dramatic and not always achievable, but we use it nonetheless to illustrate the power of compounding that can occur when one uses the bedrock trading strategies of the options market to generate income.
To be sure, the return on cash can be attractive for cash-secured put sales when compared to the stock’s dividend yield, and other metrics. Return on cash is calculated as follows: premium/(strike-premium) = return on cash. For example, an investor who receives a $2 premium for selling a put on a stock that expires in two months, at a $50 strike price, would have a return on cash of 4.16%. The return on the cash can exceed many fixed income or money market instruments.
The graph below illustrates the mechanics of a cash-secured put strategy designed to generate income: