In February, I recommended a biotech stock called Ariad Pharmaceuticals (NASDAQ: ARIA) to my Real Income Trader readers.
The stock had been at $25, as its lead drug, Iclusig, was putting in very compelling trial data and was just hitting the market. It looked like a potential blockbuster…
But then a safety warning caused Iclusig to be pulled from the market, and Ariad shares plummeted down to $2.50. I waited and recommended the stock to my Real Income Trader subscribers as it was breaking out once the safety concerns were addressed and the drug was headed back to the market.
Our entry was $8.78 a share.
I didn’t think the stock was going back to the $20 to $25 range, but I did think something around $15 was reasonable. But that wasn’t the only reason I recommended the stock…
Biotechs have been very hot stocks for the last couple of years as the promise of gene-based drugs is now being fulfilled. Big Pharma needs new blockbuster drugs, and there have been an incredible number of buyouts and acquisitions.
But even more than that, Real Income Trader is a covered call trading service. We buy shares of good stocks between $5 and $15, and then we sell call options against those shares for cash income.
It’s a pretty simple process. We always sell call options that can only be exercised at a price that is higher than where the stock is currently trading. So if we have to sell the shares to meet the terms of the call option contract, we do so at a profit. And of course, we also keep the cash we get for selling the call option.
It’s a pretty profitable process, too…
We’re never really in danger of losing very much because we are consistently taking in cash that offsets losses if the stock falls in value.
For instance, with Ariad, over the last 18 or so months, we’ve sold call options 10 different times, roughly once every six weeks. So far, we’ve taken in $3.78 a share in cash from selling Ariad call options.
On a 1,000-share position, that’s $3,780 in cash. And we still own the stock, too. You can also think of it as lowering your cost on the stock. With Ariad, we lowered out $8.78 entry to $5. It’s like taking your profits in advance…
Ariad Buyout
So obviously, the stock market has been a bit dicey over the last couple of weeks. It’s been great to be able to add some cash to our accounts as the market has tanked. Selling covered calls is an excellent way to protect your investments when the stock market goes south.
But on Friday, my Real Income Trader subscribers got a great surprise: Ariad shares launched around 40% on a buyout rumor. Actually, it was more than a rumor…
Back in April, a hedge fund called Sarissa Capital (which is run by a former Carl Icahn protégé named Alex Denner) raised its stake in Ariad to nearly 7% and demanded that Ariad CEO Harvey Berger resign and make way for the company to be acquired.
Well, Berger retired in May, and the door was open for a buyout. That possibility became a reality on Friday, when it was reported that another biotech, Baxalta (NYSE: BXLT), was in active talks with Ariad about an acquisition.
Seems to me it’s just a matter of time…
Right now, I think the buyout price will be between $10 and $11. At $10, the gains for Real Income Trader will be an even 100%. At $11, the total profit will be 120%. And those solid gains have been achieved largely because of the cash we have taken with covered call sales.
Without those call sales, our profits would be significantly lower — in the 14% to 25% range. Clearly, a well-executed covered call strategy can add a lot of juice to your investment returns.
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Covered Call Options: Safe and Profitable
Stock options get a bad rap. People say they are just for gambling, you will lose money if you buy them, and so on. And if you buy options as a wager on how a stock will move, yes, you may lose money if the stock doesn’t behave as you expect.
And let’s face it: Stocks don’t always move as we expect.
What’s more, options are contracts that expire at a certain date in the future. It may be a few weeks or even a couple years, but option prices can steadily erode as they approach their expiration date. And most options expire worthless.
So this threat that you are likely to lose your investment if you buy options tends to scare people away.
Plus, there’s a fair amount of terminology unique to options that can be intimidating to individual investors.
And this is too bad, because they are missing a whole other way to use options to lower their market risk and generate steady profits.
Let me explain…
Have you ever thought about the people that sell options?
Like with any transaction, there is always a buyer and a seller. The buyer spends the money, and the seller receives it.
It’s the same with stock options: When you sell a covered call option, the buyer pays you, and cash is deposited into your account in a matter of minutes.
You keep that money. It’s yours no matter what happens to the stock.
If the stock rallies past the price at which you agreed to sell, you keep the money from the covered call plus the profit from the stock. If the stock moves sideways, you keep the covered call money and the stock. And you are free to sell another call, taking in more money.
If the stock moves down — which is always a risk in the stock market — you have the cash from the covered call sale to offset the stock price decline. Here again, though, you still have the stock and will be free to sell another call, take in more cash, and further offset any losses.
There are no limits to how many times you can do this.
There aren’t many win-win situations in the stock market. Covered call trading may be the closest thing to it.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
