I seem to have struck a nerve with my call for a reverse split in USO.
And that’s a good thing.
When nerves are struck, opportunities for enlightenment emerge. I would be remiss, not to mention a sorry excuse for a mentor, if I didn’t take the time to clarify a few things. See, you shouldn’t much care if the white horse of reverse split salvation swoops in to rescue USO from an ignominious fate.
We’re all better off, trust me.
The primary concern seems to be the increased cost for deploying covered calls if USO should magically jump to $40 or $100 a share. At its current perch of $11, it costs a mere $1,100 to buy 100 shares of USO. If you’re trading on margin it’s only $550. The low price tag obviously makes it an ideal candidate for the beloved covered call strategy.
But, let’s continue to play this movie out. As mentioned in Free Oil. You Heard it Here First! USO will reach zero by September 2016 at its current rate of decline.
I know, I know, it won’t go that far. Fine. But let’s say it drops to $7. Do you realize the increased difficulty of trying to consistently sell covered calls on a stock in the single digits? It’s not easy for two reasons. First, even if the options are listed in 50 cent increments, that’s still an 7% jump (0.50/7) as you move from one strike to the next. That means the second strike price OTM is 7% further away than the first strike price OTM. As a result you’re probably relegated to only selling the first strike OTM. Some months the ATM option may be the only call with any premium worth selling. That seriously limits our flexibility in trying to efficiently sell covered calls on USO.
The second reason is the same one mentioned in Why USO Needs to Split…Pronto. The premium you’re able to receive selling calls on super low priced stocks is peanuts. If USO continues plumbing the depths it will get to the point where your commission costs to enter and exit the short call become too burdensome.
Now, that’s not to say you can’t keep doing it. Trade away my friend. All I’m saying is it’s much more efficient to deploy the covered call strategy on a $40 stock with call options listed in $1.00 increments (that’s 2.5% apart) that offers premiums ranging from 50 cents to $1.50, versus a $7 stock with calls 7% apart offering a mere 8 cents to 30 cents of premium.
Now, what of the additional cost to snatch 100 shares of the $40 stock. We’ve increased the cost from $1,100 to $4,000. Suppose we lack the capital to make a $4,000 covered call trade a feasible proposition.
Then sell naked puts. I bet the margin requirement for selling an OTM put on a $40 stock isn’t any greater than the cost for initiating a covered call on an $11 stock.
Can’t sell naked puts?
Then do a bull put spread. I mean, you could short a 40 put and tack on a long 30 put for a mere penny just to cap the risk. Your cost would still be cheaper than the covered call on USO at $11. But the trade would net you more cash flow for the commission required.
Nerve Striker, out.
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