Tuesday, October 6, 2015

Writing Covered Calls On TGH Position To Earn Extra Income

A few days ago I wrote about my purchase of additional TGH shares. One of the reasons for my purchase was that I wanted to "experiment" a little bit with writing covered calls. This post will explain my reasoning and will show the calculations of expected values in different scenarios.

I own 100 shares with a cost basis of $24.13. Shares of TGH are currently worth $18.50 and had a nice run up in the last few days. However rental rates remain under pressure and my investment thesis is that revenues could decline in the coming quarters because of expiring leases. Renewal rates are lower than they were locked in 5 years ago so this has an impact on the bottom line. In my analysis for a worst case projection, I reckon the current dividend should be safe. So an investor in TGH is mostly interested in dividend in the short term and maybe some capital gains in the medium term.

If you expect the share price to remain more or less stable (or somewhat lower), writing a covered call option is a good strategy to earn extra income. By selling a call you give the buyer of the call the right to buy TGH stock at the strike price. I cover this call with my 100 shares and they are called away if the share price is higher than the strike price. I get to keep the premium but lose the shares.

I've put this little story in a graph.


The red line is the value of my position without the option. So the current price is $18.18. If the share price increases to $20, the added value is roughly $2. If the share price declines to $16, I lose $2. Simple, right?

The blue line represents the value of my position with the option. It's based on a few things:

  • Strike price: $20
  • Option premium: $0.40
  • Commission: $2.30
  • Expiration date: November 20th
If the share price of TGH remains below $20 before the expiration date, I will get to keep the premium minus the commission. This adds a value of roughly $0.38 per share. That's why the blue line is above the red line in the left part of the graph. If the share price exceeds the strike price, I no longer benefit from the upside. The break-even point is at the strike price plus the option premium minus the commission costs, in my case $20.38. If the share price moves beyond this point, I would have been better of by not writing the call option. If the share price remains below this point, I will benefit from my decision.

Based on the premium ($0.38), current share price ($18.18) and duration (44 days) this trade will yield an annualized return of 19% if the share price remains stagnant. So to summarize: because I don't expect any short term upside for the share price of TGH, I exchange the upside potential for downside protection by generation extra option income.

Finally, I noticed that the spread between the bid and ask price was relatively high for TGH options. This was a bummer, because it lowers the chances for successful investing. I will do some further research about this issue and whether to continue with this strategy or that I should use more liquid companies.

What do you think about my strategy?

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