- 2002: Volume 11, No. 3 Modification of the Buy and Hold Investment Strategy

The most common stock market strategy used by public investors is "buy and hold." This means they buy stock and seldom, if ever, sell it. For some, selecting a stock to buy is easy, but selling is an almost impossible decision to make. These investors become buy and hold investors by default.

The buy and hold strategy has been successful over the long-term, as the stock market has risen steadily in recent decades. Anyone who bought stock and held for long periods of time was usually a very satisfied stockholder. There were periods of no growth and even negative growth, and there were stocks that did not participate in the steadily rising market, but the vast majority of those who held their investments through all market climates were winners. Today's investors want to know: is "buy and hold" still the best choice for public investors today?

Time to Change With the Times?
The recent past has made some people re-evaluate this strategy. People watched with astonishment (and jealousy) as stock prices rose steadily, often day after day, for no apparent reason. Investors no longer had reasonable profit expectations. For some if a stock didn't double every six months, it wasn't considered a winner. Those investors who owned technology stocks were unwilling to sell any stock during these years, since the rate at which they were making money was so great. In saner times those rates of return would have been considered unbelievable. In the latest stages of the bubble, these returns were considered normal and reasonable. Thus, even investors who did not really want to continue to hold their stocks felt compelled to do so.

Many investors who had watched from the sidelines were unable to remain spectators any longer and finally joined the frenzy. When the bubble burst, and the NASDAQ index dropped from over 5,000 to below 2,000, many investors lost most, or all, of the money they had made in the previous few years. Those who joined the game in its latest stages lost more than just their earlier profits. Some investors have dropped out of the market completely; others have reverted to their old strategies, hoping it will again produce investment profits. The giant technology bubble has given many investors doubts about how to invest in the current market.

The point is that many investors are now afraid to buy stocks and have to hope for the best. Others are afraid to buy stocks at all. Many do not know what to do and are seeking guidance.

The purpose of this article is to show you how to modify the buy and hold strategy. The modification makes it more likely your portfolio will be profitable at the same time it affords some insurance, in the event stock prices go lower. This is an excellent combination of attributes for a portfolio in these times. The strategy has much in common with the original buy and hold strategy, because it is built on the same foundation, the necessity of carefully researching and selecting stocks to buy. In order to gain these two advantages and apply the modified strategy, you must give up the chance to make a bonanza on any one stock. In the years around the turn of the millennium, going for the bonanza was the name of the game, but now is a time for a more realistic investment strategy.

Because you are investing in the stock market, the most important (and obvious) factor in determining your future success is your being able to avoid buying stocks that undergo severe price declines. It is more necessary than ever to do your homework and to be confident in the future of those companies in which you decide to make an investment. With the modified strategy, you can make good money even if your stocks do not rise significantly in value, as long as you avoid debacles.

Once you have done your research, made your decision and bought your stock, I want you to consider making a change to your usual buy and hold technique. This suggestion may seem unusual, but it provides an opportunity for increasing the profit potential of your entire investment portfolio.

Consider making a deal with someone else—offering to sell your stock to that person for a limited period of time and for a predetermined price. In return for the right to buy your stock, the other party pays you cash. You get to keep that cash, regardless of whether the other person buys your stock at a later date or not.

The situation just described is what occurs when you own stock and sell a call option (see Covered Call Writing Explained). The strategy is called covered call writing (write is a term often used in place of the word "sell"). Don't panic. You may have heard that stock options are only for speculators, but that is a major misconception. Options can be used as very conservative investment tools, and the strategy described here is among the most conservative (it is the only options strategy an investor is allowed to use in a retirement account).

Covered Call Writing Explained

A call option gives its owner the right to purchase 100 shares of a specific stock (underlying) at a specific price (strike price) for a specific period of time (until expiration). The option owner has the choice-he does not have to buy the stock; he merely has the right to do so. If he elects to buy the stock at the strike price, then he exercises his option. If he does exercise, you, as the call seller, are obligated to sell the stock at the strike price, regardless of its current market price. The option buyer pays a premium to the seller (you). The premium is not a down payment, but is the price of the option. You keep the premium, no matter what. If you own 100 shares of stock and sell (write) a call option, you are covered. This means you own the stock and can deliver it to the owner of the call option, if he chooses to exercise that option. Having sold the option, you wait. You have no control on whether or not the option buyer will take your stock. If the stock pays a dividend while you still own the stock, you keep the dividend. If the expiration date passes and the call owner has not exercised the option, you have no further obligations, as the option is no longer a valid contract.

You just spent time and effort researching a stock to buy, and now I am suggesting you sell it. Is this really a good idea? You bought this stock to make money in the coming years, as the company grows and its stock becomes worth more and more, so why would you want to sell it so soon? These are good questions, so let's consider the answers.

Why Would You Want to Sell a Call Option? What Do You Have to Gain?
Over many years, stocks have grown at a compounded annual rate of 10 to 11 percent. I cannot know how much growth you hope to achieve from your new investments, but let's assume you want to do better than the historical number and are aiming for 15 to 20 percent growth. If it is upsetting to you to aim for a lower rate of return on your investment than was available for a short period of time in recent years, you are not being realistic. A return of 15 to 20 percent is outstanding and allows your money to double approximately every 3-1/2 to five years.

Here is a question for you to consider: Do you care if you make the target growth of 15 to 20 percent because the price of the stock goes up, or if you are able to make that amount, or more, from selling call options? Suppose you are able to achieve that growth in the value of your investment at the same time you are given some insurance (a limited amount) in case your timing is poor and your stock(s) actually goes down in price. Doesn't that sound like a good scenario: insurance coupled with the growth you want? Let's see how this can be accomplished by the use of call options. Afterwards, we will answer the questions: If this is so good, why doesn't everyone do it? What can go wrong?

Let's use as an example a stock (WXYZ) trading for $40 per share. Let's also assume you sell a call option with six months until expiration, granting the option buyer the right to purchase your stock for $40 per share, and you receive a premium of six. (This is $6 per share. Since the option is for 100 shares of stock, the cash you receive for selling the call is $600).

You have $4,000 invested (current price 40; 100 shares) in WXYZ stock. After selling the call option, you apply the entire proceeds from the sale of the option,(don't forget to include the cost of commissions, ignored here for simplification, in your calculations), reducing your net investment to $3,400 ($4,000 less $600).

Even though you bought this stock with the plan of holding it for future growth, you may have to sell it for $40 when the option expires (discussion below). If that happens, you have a profit of $600 on an investment of $3,400. In six months, that is a return of 17.6 percent. On an annualized basis, that is more than 35 percent, and considerably more than your hoped-for return. You may not want to sell your stock (actually, selling the stock can be avoided, but for the purposes of this article, let's keep it simple), but if you can make this much return on your investment, that is a pretty good consolation.

When you adopt this method, the profit potential for any stock in your portfolio is going to be dependent on the cash you receive when you sell the call option. The premium varies by a large amount, depending on the nature of the stock, the amount of time until expiration as well as other factors. A volatile stock (see Volatility/Beta) has options priced much higher than a non-volatile stock. Companies with volatile stocks tend to be newer, smaller, and in fast-growing industries. Companies paying large dividends or in stable, non-rapid growth industries tend to have less volatile stocks.

Volatility/Beta

Volatility is the property of a stock that describes its tendency to undergo price changes. More volatile stocks undergo larger or more frequent price changes. It is an absolute term, and measures the price movement without regard to the price movement of any other stocks. In the options world, volatility is a stand-alone calculation. In the broader investment world, a more common measure of volatility is Beta. That is the term used by such companies as Morningstar and Standard & Poors when they describe the volatility of a stock. Beta is a relative term, and is a measure of the price movements of an individual stock, when compared with the price movement of the S&P 500 Index. Because option buyers make money when stocks undergo significant price changes, they pay a much higher premium for options of volatile stocks. Thus, as an option writer (seller) your potential profit is greater if you own, and sell a call option on, a more volatile stock. This does not mean you should only buy volatile stocks, it means the less volatile stocks in your portfolio have a lower profit potential from selling options.

If you adopt this strategy, you want to own stocks that have option premiums high enough for you to earn a reasonable return. Does this mean you should take the volatility of the stock into consideration when you prepare a list of stock to consider buying? Yes, for it is just one of the many factors that should go into your decision making process. I am not suggesting you buy speculative stocks. Continue to choose stocks as you normally do, but take a look at the volatility (beta coefficient ought to be a number readily available to you—see Volatility/Beta). It might help you to choose between two similar stocks.

Returning to our example, let's assume time has passed and that it is now six months later. It is after the stock market has closed on the day the options expire and we can compare expiration possibilities. While evaluating results, let's also compare this covered call writing strategy with the buy and hold strategy.

Scenario One:
The Stock is Under the Strike Price of 40
The call option is out-of-the-money. The owner of that call option is not going to pay 40 for your stock. If he wants to own the stock, he could have bought it this afternoon, before the market closed, for a lower price. This is not your concern. The important point for you is that no one is going to exercise the call, and it is going to expire worthless. You are no longer under any obligation to sell the stock for $40, or for any other price. The option is no longer a valid contract.

This is a good result. You are not pleased your stock has declined in price, but you are better off by $600 than if you did not sell the call. If the stock is still over 34 (your net cost), you have a profit. If your investment shows a loss, that loss is $600 less than the buy and hold investor lost.

I want to stress one important point. You have a profit any time the stock is over 34, (your reduced cost). In order for the buy and hold investor to have a profit, the stock must be over 40 (his cost). Since it is more likely the stock will be over 34 than over 40 when expiration day arrives, the modified strategy is more likely to show a profit than the standard buy and hold strategy.

In this scenario, the covered call writing strategy is clearly superior to the buy and hold strategy.

Scenario Two:
The Stock is $40, or the Strike Price
The call option is at-the-money. You do not know whether the owner of the option wants to take your stock or not. You will know next Monday morning (sometimes the information is available online Sunday, but this depends on your brokerage firm) when you call your broker to ask. Please remember to call, because some brokers are slow to give you this important information.

If you did not sell your stock, the option has expired worthless. You have a $600 profit and still own the stock. That is a very good result, for you are $600 better off than the comparable buy and hold investor. You are in a position to decide if you want to sell another call option, or revert to the buy and hold strategy.

If you did sell your stock, you have a six-month profit of 17.6 percent. This is a good result. Since the stock is $40, you may decide to buy it again. If you do, you are in a position to sell another call option, or revert to the buy and hold strategy.

In this scenario, the covered call writing strategy is clearly superior to the buy and hold strategy.

Scenario Three:
The Stock is Over the Strike Price of $40
Your option is in-the-money. Whoever owns the option is going to buy your stock for $40. You will get the official notification from your broker Monday (or Sunday online). This is a good result, since you have made your (consolation) profit of 17.6 percent in six months. You have the proceeds from the sale of the stock to reinvest whenever you choose to do so. By the way, this is the situation that makes it important for you to maintain an updated list of possible future investments.

This is a good result for everyone, but (see below) it is not clear whether you or the buy and hold investor made more money.

Is it this easy? Why doesn't everyone use this strategy? If all the results are good, what's the problem? What can go wrong? These are good questions; so let's examine the risks of the covered call writing strategy.

What Can Go Wrong?
What Are the Risks?
Selling covered calls instead of simply holding stock is a strategy that makes money (the profit is limited) more often and loses money less often. You can lose money only when the stock goes down, but, since you have the proceeds from the sale of the call, you always lose less than if you did not sell the call. In comparing the two strategies, the covered call strategy always performs better if the stock declines in price.

There are other situations in which you would have been better off by not selling the call. Let's take a look at them.

1. If the stock rises through the strike price and continues to rise, you may make less money with the covered call strategy. Once you sell the call, you can no longer sell the stock during the lifetime of the option, unless you buy back that call. You must hold your stock so you can deliver (sell) it to the option holder if he eventually exercises his rights. Thus, when you sell a call option, the highest possible price you can get for your stock is the strike price. In our example, if you eventually sell your stock to the option holder for 40, your profit is limited to $600. Thus, if the stock goes higher than 46, (the point at which the buy and hold investor also has a $600 profit) the buy and hold investor makes more money than you. Note that some inexperienced investors believe they have suffered a loss in this situation. Do not fall into that trap. You have a profit. It may be a smaller profit than you would have earned if you did not sell the call, but it is a profit. Also keep this in mind: the person who bought your option is entitled to make money at least part of the time. If option buyers never made money, there would be no one to buy your calls when you want to sell them. Be happy with your $600 profit and move on to another investment.

2. Thus, if the stock goes higher than 46 (a stock price increase of 15 percent), you would have made more money holding the stock and not selling the call. This is one of the risks of the proposed strategy.

Sometimes selling a call represents an attempt to sell stock at a price higher than the current price. In our example, if your goal is to sell the stock for 46, you have two ways to accomplish that goal. The traditional method is to call your broker and enter a good 'til cancelled (GTC) order to sell the stock if and when it reaches 46.

An alternate way to sell stock for 46 is to sell the option for six now (as you did in the example), and hope to get 40 for the stock later, when you are assigned on the call option.

Where does the risk come in? If your goal is to sell the stock for 46, and if you choose the call option method, there is a chance to lose the sale.

If the stock trades for 46 or higher during the lifetime of the call, you would sell the stock if you simply entered an order with the broker. With the covered call strategy, you would have to hold the stock for possible delivery to the owner of your call option, and would be unable to sell for 46. If the stock then reverses direction and is below 40 (strike price) when expiration day arrives, you will not sell your stock, as the option expires worthless. You have $600 as consolation, but you still own the stock. If the stock is near 40, you are in a reasonable position, as you can sell another call option, collect another premium, and have another reasonable chance to sell the stock. But, if the stock is significantly below 40, it is going to be difficult to achieve your goal of selling the stock for 46.

Thus, one of the risks of selling a covered call is that it may result in missing the opportunity to sell the stock. This is not a direct comparison with the buy and hold investor, for it is unlikely the buy and hold investor is interested in selling the stock for 46 (or any other price). You may have lost a sale opportunity, but you came out better than the buy and hold investor.

3. If you own stock that pays a dividend, there is a risk you will lose the dividend. The owner of the call option has the right to exercise the call option and buy the stock at any time before the option expires. He may choose to exercise it, and claim immediate ownership of the stock, the day before the stock goes ex-dividend. (To collect the dividend, you must own it before ex-dividend day.) The buy and hold investor always receives the dividend.

Risk Summary
The modified buy and hold strategy, called the covered call strategy, makes money more often and loses money less often than the buy and hold strategy. However, there are times when it does not produce the best result. It may result in the loss of a dividend, it may cause you to lose the sale of the stock at your target price, and it may limit your gains when the buy and holder is collecting a bonanza. Yet, I highly recommend that you at least consider adopting this method.

Downside protection is valuable in uncertain markets. The increased chance of showing a profit is valuable. To me this combination more than compensates for the risks associated with this strategy. It is your money and you must make your own decision, for not every investor thinks alike.

Your Investment Future
If you do choose to proceed, remember each stock in your portfolio requires a separate decision. It is not necessary to sell a call against each of your stock holdings. In fact, I suggest you begin with only one or two positions and gradually increase the number as you become more comfortable with the strategy and more satisfied with the results.

When doing research, you may want to have an idea of typical prices you can expect to receive when you sell call options for of a particular stock. Option prices are available for no charge via the Internet, or from your broker.

This article is an introduction to the topic, for there is much more to be learned about the covered call writing strategy. For example, which of the several available strike prices do you choose when selling the call. Which of the four possible expirations do you choose? There is no single right answer. The purpose in writing this article is to introduce you to the idea and to try to convince you to seriously consider modifying your current strategy. More information is available from your library, bookstore, broker, or me.

So, What Is Right For You?
The recommended strategy requires you to be diligent when selecting stocks to buy, but no more diligent that your current strategy. By selling covered calls against your stock holdings you give up the chance to make a killing on any one stock, but in return you have a much better chance to show a profit for each of your stocks. Those additional profits add up over time and can make a significant contribution to your financial health. Portfolio protection is another bonus.

Discuss this idea with your financial advisor or broker. Be aware that some professional investment advisors do not understand options as well as you do (now that you have read and understood the contents of this article), and may be reluctant to advise you to adopt this strategy. They may even suggest that you would be making a big mistake to consider using options. Don't be easily intimidated, as you are entitled to an advisor who does understand options. If your broker is reluctant to speak with you about options, or if he tries to steer you away from them, ask the branch manager of your brokerage house to allow you to speak with another broker who does understand options and who will be receptive to your adopting a conservative options strategy. The manager does not want to lose your business and should accommodate you. An alternative is to open a second account with a broker who understands the power behind using options in a conservative manner. Give him your covered call business and maintain your buy and hold business with the original broker. Eventually you may be able to consolidate your accounts again. If you currently use an online broker and make investment decisions without professional advice, there is no reason why you should not be able to continue doing that with options. If you have a basic question about getting started with options, their customer service department ought to be able to assist you (or send me an e-mail and I will try to give a satisfactory reply).

One final thought: Although covered call writing is a conservative investment strategy, as with any situation in which you are invested in the stock market, losses can occur.

Glossary

Call—an option giving its owner the right, but not the obligation, to buy 100 shares of a specific stock (underlying) for a specific price (strike price) for a specific period of time (now through expiration day). Put—an option giving its owner the right, but not the obligation, to sell 100 shares of a specific stock (underlying) for a specific price (strike price) for a specific period of time (now through expiration day). Exercise—the process by which the option owner notifies the option seller that he is doing what the option contract allows: either buying (call option) or selling (put option) the underlying stock at the strike price. Assignment—The process by which the option seller is notified that the option owner has exercised his rights, making him obligated to fulfill the conditions of the contract and sell (to the call exerciser) or buy (from the put exerciser) the underlying stock at the strike price. At-the-Money—the situation occurring when the underlying is the same as the strike price. In-the-Money—the situation occurring when the strike price of the call option is lower than the price of the underlying stock. Out-of-the-Money—the situation occurring when the strike price of the call option is higher than the price of the underlying stock. Expiration—The last day the option is a valid contract. Expire Worthless—the situation occurring when the option is out-of-the-money at expiration and the owner does not exercise it.

Mark Wolfinger has been involved in the options business since 1977, when he began his career as a market maker on the floor of the Chicago Board Options Exchange. Besides being a trader, he has helped train new traders and worked as a risk manager. He now teaches public investors how to use options conservatively and intelligently. His recently published book, The Short Book on Options: A Conservative Strategy for the Buy and Hold Investor can be ordered at any bookstore or from the author through his Web site: www.mdwoptions.com. His e-mail address is mark@mdwoptions.com.