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Covered
Calls, Best of Both Worlds
Research for Online Investors
This originally appeared in MarketToday on 4/28/10
Selling covered calls is confusing to some, and when we don’t understand something, it is easy to
discount the importance of the strategy. Much has been written that can confuse the reasons to use this strategy. Let’s look at selling covered calls, and
why it may fit your investment objectives.
There
are two basic kind of stock market participants; investors and traders. Which are
you? Do you watch every
business show on TV? Read
magazines and newspapers for economic information, looking for a gem of a recommendation on a company that could
break out in the near future? Do you keep your computer turned on with your online
stock platform running so you can check quotes and watch the stocks you own? You’re a
trader!
Do
you watch the evening news and comment to your wife on a business or political story that seems bad for business or
the economy? You might be an
investor.
Making this list made me feel like Jeff Foxworthy, can’t you hear him say, “If you were glued to
the TV watching Lloyd Blankfein of Goldman Sachs testify before congress, you might be a stock market
addict!”
The
beauty of selling covered calls is it gives you the best of both worlds. You can invest in quality companies or ETFs for
long term gains, but sell covered calls for income and downside protection. You can invest AND
trade.
Why
do I say that? The number one
criteria for your underlying stock investment is a quality company whose stock is going to rise in the
future. This is of paramount
importance, as selling calls against a depreciating asset is a tough game. You are chasing the stock down continually
buying protection, with lower strike prices to keep a reasonable premium.
Our
second criteria is picking a stock or ETF with enough volatility to command a reasonable option
premium. Of course, we all
feel the most comfortable with the biggest of the blue chips, but you must have some implied, or expected,
volatility for buyers of options to risk their money to ‘bet’ on the price being higher in the
future. If a stock trades in a
tight trading range, and never moves, who would pay green money for the chance to buy it if it went
higher?
Look
at it like this. Gamblers can win at a
casino. People go to a casino because they have a CHANCE to
win. The house takes their money, and lets a few take some back
home. We have to sell an option that has a chance to win, but just
like the casino, we get to keep the money whether the buyer wins or
not.
If we
bought a six dollar stock and sold a covered call against it for June expiration for 55
cents. That would mean
we would make 10.1% in seven weeks if the stock was higher than $6 dollars on June 18. I don’t know about you, but I like the
idea of making 10.1% in seven weeks. If you could do that over and over it would annualize at 75% We can do it again and again, but there
are some days lost. What
if you could do it even 4 or 5 times a year? That still works out to a pretty good
return.
The
protection in the trade is if the stock is trading for less than $6 on June 18 You get to keep the stock and the 55 cents paid
buy the option buyer, so now your cost in the stock is only $5.45 What do you do? Sell another $6 call for August expiration for
60 cents. If it is trading
higher than $6 on August 20, you make 23.7% on your original six dollar
investment.
I
think you get the idea. Just
continue selling the calls and taking the income. Let the option buyer call the stock away, so
they win once in awhile. Book
the profits, and start over again!
It
sounds simple, it isn’t always. Stocks can fall out of bed, creating a gut wrenching decision. Surprisingly, one of the bigger concerns to some
investors is a stock that goes parabolic and they must let it be called away for much less than the market
price.
What
are you going to do? Cry over
the gambler winning one once in a while? I am happy to make a nice return, with my covered call sold for income and
protection.
Let the gamblers play their game, I’ll play
mine.
The information presented in this newsletter is based on generally available news
releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you
believe you have read here. Do your own research, it is your money.
If you lose it, it is your responsibility, not ours or your grandmothers!
The editor may or may not have a position in any securities discussed.
The editor may have held a position in a security earlier, or in the
future.
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