Q. I fear that I have been talked into doing something with my new money manager that I don’t understand and with which I am not comfortable. I’m usually pretty independent for a widow in her 70s, but since my former adviser retired and recommended this new adviser as his successor, I think I need to give him a chance.
This man is completely different from my former adviser, and I’m not really sure why he chose this man as his successor. I ask questions but he either isn’t explaining things very well or it’s just too complicated for me to understand. He’s also a fast talker and kind of slick. I am not a financial genius by any means, but I’m no dummy, either!
At my request, a friend accompanied me to a meeting and took notes. He explained that since three highly appreciated stocks make up a very high percentage of my total portfolio holdings, he eventually wants to sell these and diversify my portfolio. I can understand his reasoning even though these are good stocks, and will go along with being more diversified. What I don’t understand is how he is planning to sell them.
He said he is going to sell some sort of options on these stocks, which will produce income until the stock reaches a certain price, and then the stock will be sold. Once sold, the proceeds will be used to buy other types of investments. I told him that I’ve always heard options were high-risk, but he assured me that since I owned the stocks I was “covered” and the options carry no risk. He then went into a quick explanation of covered calls before he needed to end the meeting.
If you understand what he is doing, can you please provide an explanation in plain English and comment on whether this type of trading makes sense in my situation?
A. If you agree that you need to sell some of your stock holdings to achieve a more diversified portfolio, the type of option referred to as a covered call may be appropriate in your situation. With that said, I would not invest with someone with whom I did not feel comfortable, or invest in something I didn’t understand and that couldn’t be explained to me.
Your new investment adviser is talking about a type of option referred to as a covered call. It is “covered” because you own the stock. If you did not own the stock, it would be an “uncovered” call (also referred to as naked). Uncovered calls are very risky and have an unlimited loss potential; covered calls are a conservative option strategy that will earn income for you. I’ll try to explain this in plain language.
Options are unusual securities in that they are actually contracts. A “call” option is a contract that gives the holder the right to buy stock at a fixed price. In some situations, it may be advantageous to sell call options.
The first step is to determine the number of shares you want to sell and the price at which you are willing to sell. Suppose you decide to sell 300 shares of XYZ stock if/when it climbs to $70 a share. You could sell one or more call options on some or all of your stock. A “call option” gives the person buying the option (option holder) the right to purchase XYZ from you at $70 a share (the strike price) for a certain period of time, usually six months. In return for the right to buy your XYZ shares for $70 each over this period of time, the option holder would pay you a “premium.” A premium is a dollar amount per share. If your premium was $3 a share, you would receive $900 (not counting any broker commissions) if you sold call options against 300 shares.
Here are the possible results if you decide to sell covered call options:
• The stock never reaches $70 over the option period, the option holder lets the option expire, and you still have the 300 shares of stock. You also have the $900 premium.
• The stock rises above $70, and the option holder decides to exercise the option. You would receive $70 a share (less commissions) for your stock. You also keep the $900 premium.
• The stock rises well beyond $70, and the option holder decides to exercise the option. You would receive $70 a share (less commissions) for your stock. You also keep the $900 premium. You would have to sell the shares at the agreed-upon price even if the market price was well above $70.
As with any financial decision, make sure you understand all the costs involved, including fees, commissions and taxes, before you proceed.
You should also know, and be comfortable with, the investments your adviser is planning to purchase with the proceeds should the options be exercised.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624