My long time readers will know that I manage my own retirement account. I am working on building my own dividend machine, piece by piece, until it becomes a full income replacement tool.
With that, I’m fairly cognizant as to what is going on in the markets as time goes on, whether stocks are cheap or not. I’ve felt that in the tail end of 2018, we were finally getting some reasonable values on stocks, most notably Christmas Eve as many of you may recall.
All 2019 we’ve been “off to the races” once more and as the first quarter wrapped up we were within earshot of all time highs once again. We’ll know in a few weeks how it all plays out as earnings season is kicking off (this morning actually).
Back in February I began writing some covered calls on positions that I held that I was willing to part with for the right price. Here is an update on one of those; Starbucks.
The Covered Call
With my aforementioned belief that the market is a bit elevated, I was looking for stocks at their 52 week high (or all time high for that matter) and came across Starbucks.
I love Starbucks don’t get me wrong. It’s still a core holding but I’m OK with taking profits here and there. Those profits can be rolled into other investments to increase my dividend stream. The old adage of buy low, sell high still applies and frankly I think that is forgotten all too often.
The Fast Graph here points out a few things to me. First, the blue line represents the average P/E ratio over the time period, in this case 11 years. While the current stock price has just peaked over top of it, the story is actually a little bit different. Investors will pay more for growth and the fact is the growth has been slowing at Starbucks. That’s OK, I just feel less compelled to pay up for it.
That said, the recent trough to peak has seen the stock rise 55% in under a year. That’s quite a swing and one that I’d be interested in taking advantage of.
If I shorten the time frame to 5 years the average P/E actually drops quite a bit and makes the current price stick out more. I think that’s warranted as the major growth days of Starbucks have passed as they reach store saturation.
In any event, back in February I wrote a covered call against my position in Starbucks.
What is a Covered Call?
“A covered call is a popular options strategy that can generate income, in the form of premiums, for an investor’s account. To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream.”From Investopedia
I basically put up an IOU that said I’ll sell my shares at $72.50, with an expiration of April 18th, 2019 and for that privilege you’ll pay me $1.27 per share. At the time, shares were trading around $70 so writing this “IOU” would net me $73.77 per share if the option was exercised (the person on the other side said yup I’ll take them).
Fast forward to a few days ago when shares were trading at $75. My option was “deep in the money” as they say and the expiration date was coming up. My trade was not working out and there was more upside to the stock than I had guessed.
Option Generator To The Rescue
He mentioned I had a few choices, among which I could do what is “roll out” or “roll out and up”. The “roll out” part means that I could buy back my “IOU” and write a new one for a later date. That implies that I also use the same strike price of $72.50.
This was not a free action! I had to pay up to buy back my option since it was now worth well over $3 per share. The current share price was over $75.50 and the option granted someone the right to buy shares at $72.50.
The “roll out and up” added a nuance where I raised my strike price on my new covered call in order to attract a higher selling price if my shares are called away.
This is the route that I took so here’s how it looked:
- Bought a call to close at $3.65, this put me back at “neutral”, this closed my earlier covered call that I wrote
- I wrote another covered call, this time for May 17th (this also comes after Starbucks reports their Q1 earnings so if the report doesn’t wow I expect shares to fall after this run-up).
- Jumped up two notches on the options chain, from $72.50 up to $77.50.
- Collected $1.35 per share in premium which gives me a target price of $78.85.
- If the option is exercised, that’s $7,885 versus my original target price of $7,377 (see above)
- I received $2.62 per share in premium income and lost $3.65 to buying back my option for a net loss of $1.03. This excludes transaction costs for simplicity.
- What I gained is the right to sell the shares for an additional $500 in total. That leaves my net at $398 ($500 – $103) upside in this scenario.
I’m a self admitted beginner at option writing but I learn best by just doing something. The end result was still going to be positive if my option was exercised. Boohoo I’d have to sell my Starbucks shares at a large profit.
In any event, my friend Option Generator reached out with some excellent advice. I was able to maneuver my way into either keeping my shares or demanding an even higher premium for them.
I potentially stand to make close to an extra $400 if the shares are exercised by the middle of May. Regardless, I still get to keep the premium paid. If the options expire worthless, I can either do this process again or just leave it alone.