## Monday, December 22, 2008

### Deciding Which Option to Sell on an Existing Position

Every options expiration weekend I go through a process of deciding which option to sell on existing positions where the current option has expired. This article will describe that process.

I start out by calculating how much option premium I need in order to provide a 12% annual yield on the original stock investment. For non-dividend paying stocks the calculation is simple, just multiply the per share cost basis of the stock by 1% to get the monthly premium required. For dividend paying stocks, I must first calculate the dividend yield based on my cost basis, not on the current stock price. Then determine how much option premium I need to add in order to yield 12% annually, and finally divide the total by 12 to get the monthly premium required.

Here are the formulas I use:

Yield on Cost = Annual Dividend / Cost Basis per Share
Required Option Yield = 12% - Yield on Cost
Required Option Premium = Cost Basis per Share * Required Option Yield
Required Monthly Premium = Required Option Premium / 12

The following are a few examples using some of the positions I adjusted yesterday.

Example 1 - ADP

Cost Basis per Share: \$43.08
Annual Dividend: \$1.32
Yield on Cost: 3.06%
Required Option Yield = 8.94%
Required Option Premium = \$3.85
Total Annual Income = \$5.17
Total Annual Yield = 12%
Required Monthly Premium = \$0.32

So, in order to get a 12% annual yield from dividends and option premiums I only needed to sell an ADP option for \$0.32 per month. Now, I wanted to go two strikes OTM on this position to get back to the original strike price. The Jan09 42.50 call had a bid of less than \$0.32 so it didn't meet my criteria. So I needed to go out an extra month, which meant I needed to get at least \$0.64 for 2 months, \$0.92 for 3 months, etc. So, I sold a Feb 42.50 call for \$0.91, which was almost 3 months worth of option premium for a 2 month call.

Example 2 - BAC

Cost Basis per Share: \$33.72
Annual Dividend: \$1.28
Yield on Cost: 3.80%
Required Option Yield = 8.20%
Required Option Premium = \$2.77
Total Annual Income = \$4.05
Total Annual Yield = 12%
Required Monthly Premium = \$0.23

In this example I only needed \$0.23 and was able to get twice that amount by selling the Jan09 16.00 call, two strikes OTM, for \$0.47.

Example 3 - BBT

Cost Basis per Share: \$33.36
Annual Dividend: \$1.88
Yield on Cost: 5.64%
Required Option Yield = 6.36%
Required Option Premium = \$2.12
Total Annual Income = \$4.00
Total Annual Yield = 12%
Required Monthly Premium = \$0.18

In this example I only needed \$0.18 and was able to get \$0.19 by selling the Jan09 32.50 call, three strikes OTM.

Example 4 - WFMI

Cost Basis per Share: \$42.82
Annual Dividend: \$0.00 (dividend suspended)
Yield on Cost: 0.00%
Required Option Yield = 12%
Required Option Premium = \$5.14
Total Annual Income = \$5.14
Total Annual Yield = 12%
Required Monthly Premium = \$0.43

This is an example of a non-dividend paying stock. In this case, the dividend was suspended. I needed \$0.43 for a Jan09 11.00 call, two strikes OTM, but wasn't able to get it. Nor could I get \$0.86 for a Feb09 11.00 call, although I could have gotten \$0.84 on a Feb09 10.00 call but that was too close to the money. So I had to settle for the Feb09 11.00 call at \$.43, about half of what I needed.

This method helps me determine how much option premium I need to meet my goal of 12% annual yield on the overall portfolio. Sometimes I get more on a given position and sometimes I get less, but on average I should be able to meet my goal on the entire portfolio. I hope this article has provided some insight into my thought process.