The Story of the Most Expensive House in Highland Park
The summertime backyard party was in full swing when the Hostess let loose a volley that shocked the guests around her. She pointed to her modest two-story home and said “that is the most expensive house in Highland Park!” The guests looked at each other with disbelief and no small degree of discomfort, having no idea what to say.
The Hostess then whirled the pointed finger towards her husband who was deep in his own conversation at the other side of the backyard. With raised voice she announced “because HE sold Coca-Cola stock in the 1950’s to pay for it.”
This is not a current recommendation for Coca-Cola. The point is that harvesting a good company can be a difficult decision.
I call the solution The Tree and The Fruit. We want a healthy tree for next years’ fruit, so we are not going to cut the tree down. There is a point each year where some action is required, a harvest. If the fruit is not harvested properly, the cash crop is lost.
The Pepsi Generation and the 10% Rule
As I studied the question of when to sell good companies, I noticed that when companies were up, clients tended to celebrate loyalty pledging to hold forever, and, when companies went down, clients regretted not selling.
At another gathering, the solution was reinforced by a former Pepsi executive. I asked, “How do you handle your Pepsi stock?” His answer was such a confirmation of our strategy that I wanted to give him a bear hug. He said, “Once a year, I try to sell 10% of my Pepsi stock within 10% of the high. I know I won’t get it perfect, but I try to sell some for other investments and expenses. Since the stock has averaged over 10%, my position tends to grow even though I am using it to build another portfolio,”>
The harvest rule comes because life gives no assurances.
The Fruit
As I researched the behavior of successful companies, it become clear that once every year or two, there is a high point that is like fruit on the ground. If you don’t act quickly, the fruit is gone.
Two methods can work simultaneously to set a harvesting discipline.
Stop Orders
A sell stop order is an order beneath the price of a stock that automatically sells if the price falls below a certain point to prevent further loss. This is where the term stop loss comes in. The order executes as a market order triggered by another trade at the given price. Therefore, the order can execute below the set price.
For example, if XYZ shares rally to $100 per share and you decide to protect 10% of your 10,000 shares, then you could put a sell stop order in at $90 per share on 1000 shares. If the stock began a decline, when XYZ hit $90, your order becomes a market order to sell 1000 shares.
This can protect the position and automatically harvest if a decline begins.
The order could fill below $90 if the next buyer is below that price. The other risk is that the shares can trigger a stop and go right back up. Stop order placement is both art and science with a general rule of about 10% below the current price to allow room to dance.
Covered Calls
Research has shown that about 75% of publicly traded stock options expire worthless. This leads to the conclusion that selling them to speculators for income might not be a bad idea.
If, in our example above, the XYZ stock rallies to $100 per share and we are not sure that we want to sell quite yet, we can agree to sell shares at $110 by July and collect a premium. If we agree to sell 1000 of our 10,000 shares at $110, and the XYZ 110 July Call option is trading at $2, then we collect $2,000 right now for agreeing to sell at $110 by July when the stock is $100.
If the stock rises above $110 before the end of the third week in July, then your shares can be called away at $110. The risk is that if the shares go above $110, you have already sold the appreciation to a speculator and must sell at $110. If you want to keep the stock, you may have to pay more than you received to close the option. The danger is that you would be forced to sell stock at $110 even though the current price is substantially higher. The opportunity cost would be missed appreciation.
The covered call premium is credited to your account at the time the option is written. If the price declines or stays below the strike price, you keep the stock and the option premium. The option premium payment is effectively a payment now for agreeing to sell shares at a higher price for a specified time. That premium credit effectively increases the net return in a stagnant position and can help build a reserve for future taxes.
Because of the importance of tax considerations to all options transactions, investors considering options should consult with their tax advisor to evaluate how taxes can affect the outcome of contemplated options transactions.
Both the covered call strategy and the stop order strategy can be used to harvest the fruit from a sound stock position without cutting down the tree.
Options involve risk and are not suitable for all investors. The stock and option prices are hypothetical and are shown for illustrative purposes only. There is no guarantee that these prices can or will be duplicated. Fees, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of the option transactions and should be considered.
When participating in a covered call strategy, the investor is at risk of having to sell the underlying stock if the stock’s price rises about the sold options strike price. Remember, in exchange for receiving the premium of having sold the call, the investor is obligated to sell the underlying stock via assignment if the option is exercised. Keep in mind that if the stock price falls, you are still a stock owner, and are subject to the full loss of our stock investment, reduced only by the credit from the sale of the call. Covered call selling is not a protective strategy. Also keep in mind when writing an option on a stock with a low cost basis, there are tax consequences to consider upon assignment.
Neither the information nor any opinion expressed herein constitutes an offer to buy or sell any security. This material is not a complete description of the securities, markets or trading strategies discussed. Additional information is available upon request. Information has been obtained form sources considered reliable, but its accuracy and completeness are not guaranteed. McGowanGroup Asset Management, Inc is a Federally Registered Investment Advisory Firm utilizing Pershing LLC, a BNY Mellon Company for asset custody.
