Charles Schwab (SCHW) stock is still trading well below what it is worth. That is good news for traders who short-sell out-of-the-money (OTM) covered calls and cash-secured puts to create extra income.
SCHW stock is at $57.83 in early trading on July 11, up $1.03. But in the last 2 weeks, the stock is up $4.66 from $53.17 where it closed on Friday, June 23.
That is when we discussed shorting its OTM puts at the $50 strike price for July 14 expiration in my Barchart article, “Charles Schwab Stock Looks Like A Good Short Put Income Play.”
At the time, the $50 strike, which was 6% below the spot price, traded for 44 cents. That represented an immediate yield to the short put trader of 0.88%.
Today those puts are almost worthless, trading for just 1 to 2 cents. That is because SCHW stock has risen, and it is exactly what the short-put trader wants to see.
Shorting Its Covered Calls
Now it probably makes sense to roll this trade over by entering an order to “Buy to Close” the prior short put trade. Moreover, investors may want to sell covered calls and/or cash-secured puts for three weeks out to the August 4, 2023, expiration period.
For example, the $61.00 strike price calls, which are 5.5% over today's price, trade for 89 cents per call option. That represents a covered call yield of 1.54% in just 3 weeks.
Here is what that means exactly. If an investor purchases 100 shares of SCHW stock today at $57.83 for $5,783, they can enter an order to “Sell to Open” 1 call contract at $61 for expiration on Aug. 4.
The account will immediately receive $89.00. That is why the covered call yield is 1.54% since $89/$5,783 represents a return of 1.54%. No matter what happens the covered call trader gets to keep that extra income.
Moreover, even if the stock rises to $61 on or before Aug. 4, the investor gets to keep the capital gain. So theoretically they could make an extra $3.17 (i.e., $61-$57.83), or 5.48%. That means the total potential return is 7.0% (i.e., 5.48% + 1.54%).
If the investor can repeat this trade every 3 weeks the annualized return is 26%, as there are 17 periods of 3 weeks in a year (i.e., 1.54% x 17x).
Shorting OTM Cash-Secured Puts
Another way to play this is to short out-of-the-money puts such as the Aug. 4 expiration $54.00 strike price put, which is 6.62% below today's price, or the $55 strike price, 4.89% lower. These trade for 68 cents and 91 cents respectively.
The premiums received represent an immediate yield of 1.26% (i.e., $0.68/$54.00) and 1.65% (i.e., $0.91/$55.00) respectively.
Here is what that means exactly. A trader can secure $5,400 with their brokerage firm in cash and/or margin. They may already own 100 shares of SCHW stock so at least half of that value can be used as margin. Then they can enter an order to “Sell to Open” 1 put contract at $54.00 for Aug. 4 expiration.
The account will then immediately receive $68. That is why the yield is considered to be 1.26% (i.e., $68/$5,400).
The same for the $55.00 strike price. Secure $5,500 in cash and/or margin and then Sell to Open 1 put contract at $55.00 The account will receive $91, representing a yield of 1.65% on the $5,500 put up.
Why Should Investors Do This?
The simple answer, as we pointed out in our last article, is that Charles Schwab is too cheap. For example, according to Seeking Alpha, SCHW stock trades for 18x earnings this year and 14x next year's forecast earnings.
These multiples are well below its 5-year average forward P/E multiple of 18.6x, according to Morningstar. In other words, SCHW stock should be trading for 18.6x its average forecast of $4.09 for next year, or $76.07 per share if it were to trade at its historical averages.
That represents a potential upside of over 31% from today's price. One reason why it might be cheap now is that investors are still scared that the Fed is going to dramatically hike interest rates, especially if inflation can't be tamed.
But that explains why the stock is cheap now. This possibility is already discounted in the stock price. That is why shorting OTM puts and calls probably make sense here, especially if SCHW stock will tread water for the time being until investors' concerns are addressed.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
