Concentrated Stock Positions

By Brian Bensch,
Vice President & Portfolio Manager

ost people would agree that too much of almost anything is probably not good for you. This is perhaps surprisingly true with respect to ownership in the equities market, specifically, concentrated stock positions.

There are various reasons why individuals may find themselves in the precarious position of owning a large block of one stock. Usually, it’s because they have worked for that company or corporation for most, or all, of their working lives, and have acquired stock over the years from stock options or pension benefits. Many are retirees that continue to hold these concentrated equity positions out of loyalty to their company, or because they feel they have too low a cost basis (i.e. tax concerns). If I were Jim Cramer I’m afraid I‘d be pushing the “Personal Foul” button, if you’re familiar with his antics on CNBC’s Mad Money. Why? Because , as even Cramer knows, the only free lunch in the stock market is diversification, and holding a concentrated position in one company’s stock, or even in an single industry sector, for any reason, is risky business. This is especially true in the wake of the Enron and Worldcom disasters of recent years.

So, what does one do when confronted with this situation? There are various investment strategies that can be utilized to mitigate the risk associated with owning too much of one stock. One strategy we employ involves the use of call options that in effect, monetize the equity position. This is covered call writing. For the purpose of illustration, we quote from the Chicago Board of Option Exchange (CBOE.com) web site in an effort to clarify the strategy:

DEFINITION:
Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is “paid” to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.

Scenario One
Buying 100 ZYX at 41.90 and Selling 1 Three-Month 45 Call at 1.25.
I. ZYX remains below 45 between now and expiration - call not assigned.
With the stock price below the option’s strike price at expiration, the call option will expire worthless. The option premium, the dividends, and the stock position will be retained. The income for the three-month life of the option, therefore, is 1.50 (the option premium of 1.25 + the dividend of 0.25). This equals 3.5% (1.50/41.90) in three months. 1.25 (Call Premium Received) + 0.25 (dividends received in this example) = Income for 3 Months 1.50 (Income)/41.90 (Stock Price) = 0.035 = 3.5% (percentage income for 3 Months). The breakeven price is 40.40 (41.90 purchase cost - 1.25 premium for sale of the call - 0.25 dividends received).

When the ZYX call expires worthless, the covered call writer can sell another call going further out in time taking in additional premium. The amount of the future premiums, however, may differ significantly from the premium of the current call price. If ZYX remains below 45 for an entire year, the investor can sell a total of four calls. Making the hypothetical assumption that the price of the stock and option premiums remain constant throughout the year, the total annual income and the annualized percentage rate of return are calculated as follows: [1.25 (Call Premium) + 0.25 (Dividends/qtr)] x 4 = 6.00 = Total Income for 12 Months. 6% (Income)/41.90 (stock price) = 0.143 = 14.3% Annualized Percentage Income.

It should be noted that the above example involves buying the stock and writing (or selling) the option simultaneously. In the case of a concentrated equity position, of course, the stock is already owned. It should also be noted that the above example is the optimal case, where the stock price stays below the strike price. Two other scenarios are possible at or before expiration, and should be discussed prior to implementation. Please call me for more detailed information.

Commission, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of option transactions and should be considered. The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.

Melhado, Flynn’s Strategic Asset Management Group: William G. Roe, Regional Manager, Allen G. Oechsner, Senior Portfolio Manager, Brian D. Bensch, Portfolio Manager, Mark Generales, Sales Manager, Ruth Hauck, Service Manager