So You've Been Assigned Shares... What Next?
Editor's note: Selling covered calls is one of Dr. David "Doc" Eifrig's favorite ways to generate safe, steady income in the market.
But it isn't the only way.
In today's Masters Series – adapted from a November 2016 issue of his Retirement Trader newsletter – Doc walks readers through a real-life trade using another one of his favorite strategies...
So You've Been Assigned Shares... What Next?
One of the tenets of our option strategy has been to ONLY open option trades on stocks we'd be willing to own.
If you're not doing that, it's probably because you don't want to tie up capital while selling naked puts. I get that, but it means you still have the same choices as always... so let's review what those are.
Remember, if you get assigned (or "put) shares – either early or at expiration – you can do one of three things...
No. 1: You can sell the shares back into the open market. If the premium you received for your put is greater than the decrease in the price of the underlying shares, then you've made money.
If the shares are trading for less than that difference, selling your shares will result in a loss. For example, say you receive $2 a share in premium to sell puts with a $50 strike price. The stock can trade for anything more than $48 a share, and you could get assigned shares and still sell them for a profit. ($50 minus the $2 premium equals $48 a share.)
Remember, when you go from selling puts on margin to owning 100 shares for every contract, you end up using more capital (naked puts only chew up 20% or so as a down payment) to hold the trade. If that doesn't fit into your plans, you can close out the position and move on to the next opportunity, or...
No. 2: Do nothing. Just sit and hold the shares... and be happy you bought shares at a discount to where they were trading when you opened the position.
No. 3: You can immediately sell call options on the shares. We like this choice because we like the idea of "selling time" over and over.
We hope you appreciate that the strike price you pick to sell new covered calls will determine many things. If you sell options at the original strike price, you're not going to get much for it... after all, the stock is down and that strike is usually now "out of the money."
You could sell a call with a strike price closer to the stock's current price, like we often do in Retirement Trader. That generates a little more premium, but you're at risk for it being called away at a loss. That could happen if the new strike is less than your total cost for the position. (That's the original put strike less the premium you have received.)
For example, you can sell a put with a $50 strike and get assigned shares for $50 because shares currently trade at $44. Let's say you then sell a call with a $45 strike price. If that option is eventually exercised, you'll receive $45 a share for the stock. But depending on how much premium you received, you may have put up $47 a share to hold the position.
On its face, this appears to be locking in a loss. In practice, we can "roll up" later on to stay profitable...
Let's take a real-life example...
Recently some put sellers were assigned shares early in the Laboratory Corporation of America (LH) position. That leads to questions on what subscribers should do next.
Let's work through the math...
Again, remember, we only sell options on stocks we want to own.
We initially recommended a LabCorp put with a $135 strike price. That meant we collected $4.30 in premium and essentially made the decision, "LabCorp is a great company. It trades for $135.80 today, and we'd be thrilled to own it at $130.70 (our cost basis)."
That's where folks who were put shares were earlier in the week. They own a quality business for $130.70 a share. We think it's more valuable than that.
So you could immediately sell and close the position. Since the stock is trading around $125, you'd be taking a loss. Not ideal, but if you need to free up capital, that's your only choice.
Or you can simply hold LH like any other investment. Our investment thesis remains solid on medical lab tests, and LH is a leader. But if you buy (at a discount and hold), you've tied up capital and aren't going to collect a dividend while you wait. (LH doesn't pay one.)
However, as option sellers, we can do better than that. We have lots of tools in our toolbox. So that lead us to our third option: to sell covered calls.
Selling call options generates income and lowers your cost basis even more. So typically, when we get assigned shares, we sell calls to improve our odds.
Sometimes we "roll down" the strike and go from, say, a $135 strike to a $130 strike. That helps us earn more income, but also caps our upside to $130 and would lock in a loss if we got called away in the next month (with a December option).
If we were confident shares would rise, we'll stick with the same strike price. That'll earn us less income from selling the options than a closer-to-the money option. But if LH rises, we'll profit more.
So in this case, we recommended selling the February $130 calls for around $3.30. If shares got called away by February, we would make the difference between $130 (the strike price) less our cost of $127.40 (the previous cost basis less the $3.30 we just collected), which is a gain of more than $2 per share.
Fortunately, whenever we're assigned shares from puts, we'll likely have an IRA Alternative covered-call position we're also tracking. That shows you what particular option we'd suggest that folks use if they decide to keep their put shares.
Getting assigned shares is a bit of a lottery. Sometimes stocks go down a bit and a few put option buyers will cash in their bets early. Whether it's you or another trader that ends up with shares comes down to dumb luck.
To repeat, consider your three possible methods to trade away from being put shares you weren't planning on owning and see which one works best for you:
- Sell the shares.
- Smile, hold, and wait for capital appreciation (and collect dividends if available).
- Sell call options on the shares and generate income over and over against all of your capital.
We suspect it's typically choice No. 3 you'll prefer, but you may feel differently. There is no one right answer.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig Jr., MD, MBA
Editor's note: Doc just made what could be the second-biggest call of his publishing career. Get the details – and learn about a special, limited-time offer to join Retirement Trader at a steep discount – right here.