Stick with Covered Calls 13 comments
Jeff Partlow
About this author:
-
Font Size:
-
Print
- TweetThis
One of the most important investing lessons I've learned is to select an investing strategy that you are most comfortable with and stay with it. That is, do not try to be "a jack-of-all-trades and a master of none." Instead, try to continually increase your knowledge related to the strategy you are using and seek to become an expert at it.
This doesn't imply that we should become rigid and inflexible in the application of our methods. To the contrary, it is essential to be life-long learners and to apply new knowledge to continually refine our approach. This is the mindset I try to maintain as it applies to my preferred investing strategy, namely covered calls investing.
In my very first blog post on this Covered Calls Advisor blog site in 2007, I stated that the essential reason why I believe in covered calls investing is that "covered calls offer an excellent avenue for obtaining market-beating results while at the same time offering the added benefit of doing so with less overall portfolio risk." My intention is to demonstrate the truthfulness of this objective over the next several years.
First, let me affirm that I do believe in the generally accepted personal financial planning principle that we should maintain a money-market account with 3-6 months of living expenses as an emergency buffer. But once the emergency fund is fully funded, additional money available for wealth creation can be committed to our preferred investing method, covered calls investing.
But why not use additional investing strategies beyond just covered calls?
From time to time there is a tendency to want to augment covered calls investing with alternative investment strategies. Some of the alternatives that have some similarities to covered calls and that sometimes seem appealing include: (1) Buy-and-Hold Stock Investing; (2)Covered Calls With Collars; (3) Selling Calls against LEAPs; and (4) Selling Cash-Secured Puts. Below is a short explanation for each of these alternative strategies that explains why covered calls are preferable, at least as far as the Covered Calls Advisor is concerned.
1. Buy-and-Hold Stock Investing: There is some research which has simulated (back-tested) over a multi-year period the results that would have been obtained by investing in covered calls via a diversified index (such as the S&P 500) and by subsequently mechanically reinvesting each month in slightly out-of-the-money, near-month covered calls. The conclusions generally support the notion that the annualized return-on-investment results (when comparing buy-and-hold with the covered calls results) are virtually indistinguishable between the two investment approaches. However, the studies also show that covered calls have only about 70% of the risk of buy-and-hold investing. It is this advisor's contention that covered call returns can outpace those of buy-and-hold investing through astute stock and strike-price selections as well as from the timely rolling of existing covered call positions when appropriate.
2. Covered Calls With Collars: This strategy is simply a covered call in combination with the purchase of a put option. This strategy is popular with very conservative investors who purchase the put option as insurance against a significant decline in the price of the underlying stock. I have analyzed this strategy several times (especially during the 2008 bear market we've just experienced), but each time I come to the same conclusion -- the cost of buying the put option is just not worth the price we have to pay for the additional insurance.
Note: I say 'additional insurance' since the call we sold to establish the covered calls position already provides some protection against a decline in the underlying stock price. The cost of buying a put option to achieve a second level of insurance is just too high a price to pay, especially if we are at all successful in our objective of selecting stocks that are neutral or bullish -- then we achieve significantly better overall returns over time with covered calls.
Remember also that our objective as investors is to 'buy' assets that tend to appreciate in value over time (such as stocks) and to 'sell' assets that depreciate over time (which is the case with both put and call options because of their decay in time value). So we want to 'buy' stocks (appreciating asset) and 'sell' call options (depreciating asset) -- which is our covered calls strategy; but also not 'buy' a put option (depreciating asset).
3. Selling Calls Against LEAPs: A few years ago, this was a strategy I used for several months before returning to covered calls. This is an alluring strategy, but it is both a more risky and, over time, less profitable than covered calls. The reason(s) for this are not readily apparent, but the primary reason this is true is the same line of reasoning above for collars, namely we want to buy appreciating assets and sell depreciating assets. The decline of time value embedded in all options (including LEAPs -- even though they do decay more slowly) ultimately makes LEAPs a less desirable asset to buy than stocks (which of course have no time decay inherent in their purchase price).
4. Selling Cash-Secured Puts: This strategy is a synthetically equivalent strategy to covered calls so in theory one should be indifferent to using either approach. In that regard, there is some appeal to the notion that one should begin a position by selling a cash-secured put and then if the put is exercised you would then be obligated to purchase the stock at the agreed upon strike price. Then, since you now own the stock you would then simply keep the stock and sell a call option against it, thereby establishing a covered calls position.
If this covered call is in-the-money on the expiration date and the stock is called away, then the natural course of action would be to then sell another cash-secured put. So the investor moves naturally to-and-fro using both covered calls and cash-secured puts as the results at each expiration unfold. This approach has some merit (when compared with using only covered calls or only cash-secured puts) in that it provides somewhat less trading friction (i.e. the costs of additional trading commissions and the pricing differences in bid-ask spreads).
Nevertheless, I have opted to commit solely to covered calls investing in the interest of clarity and simplicity. Owning covered calls in your brokerage account makes it crystal clear at all times what the current cash balance in your account is. Not so with cash-secured puts since at any given time it is more difficult to distinguish between the total amount of cash that is commited to securing the put options and the cash that is truly available for use. In this regard, one is more likely to oversell puts and to then be in a position where we are forced to sell out of a position or to trade on margin (Note: the Covered Calls Advisor is strongly opposed to margin account investing).
The four alternatives to covered calls investing described above are certainly not intended to be a comprehensive list. But they do represent the types of strategies that have periodically been mentioned as possible alternatives to covered calls in various posts on the 'justcoveredcalls' Yahoo Group site.
Although the Covered Calls Advisor is uncommonly committed to covered calls investing, from time to time even I have flirted with other possible investing approaches. But there is a lot to be said for not over-complicating our investment decision-making processes. And the more strategies we are willing to use in our portfolio, the more complicated our investing becomes, and the more difficult it is to decide what strategy to use for what stock in what situation. And these complications just beget more confusion and second-guessing which can readily become psychologically debilitating.
Committing to a single investing process (hopefully you'll agree that it should be covered calls), gives us a much better chance at achieving a characteristic shared by all great investors -- a calm, dispassionate big-picture perspective; and the possibility of enjoying the time we spend on our investing research and analysis.
Related Articles
|
Find People on SA
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largest
increase in followers
in the last 7 days-
1
David Fry
-
2
Philip Davis
-
3
Bill Gross
-
4
Tyler Durden
-
5
TraderMark
Fastest Climbers » -
1
-
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 13 comments:
One additional strategy you didn't mention would be covered combinations, owning the shares and selling equal amounts of puts and calls. The theory is that the stock can't go both directions at once, so at least one of the options sold is gravy. The strategy is attractive at times of high volatility. Owning 300 shares, I might sell 3 calls and 2 puts so as to have a little cushion, the plan is if I am assigned on the puts I have the shares I own available to meet the obligation using margin. I agree about not using margin, but by matching the puts sold against shares owned it gets around tracking the cash used to secure the puts.
On selling calls against LEAPS, it's a good strategy for what I think is a market bottom because it provides leverage. Using a stable, dividend paying stock, and buying the LEAP fairly far in the money, the time cost is not that great and can be recouped by selling short term out of the money calls against the LEAP. AN example of the type of stock I use for this would be IBM or JNJ.
Excellent writeup on covered calls. I see another benefit of the strategy you describe as being volatility affecting premiums- so risk profile of a covered call portfolio remains relatively stable against a backdrop of a whipsaw market. Stocks bounce around more but premiums increase to compensate.
I agree with Tom on LEAPS. LEAPS DITM, at around 50% of stock price can be a nice way to introduce a prudent level of leverage safely into a covered call strategy. The time decay involved is usually no worse than margin rates over the life of the position.
I find LEAPS on indexes (I.e. DIA, FXI, IWM) particularly compelling - often the same premium as conservative stocks such as what Tom mentioned but with no security risk.
On Jan 04 07:51 AM Tom Armistead wrote:
"if I am assigned on the puts I have the shares I own available to meet the obligation using margin"
assignment of puts results in buying shares, I'm not sure I follow what you mean about having the shares if assign on your puts.
> Good article.
>
> One additional strategy you didn't mention would be covered combinations,
> owning the shares and selling equal amounts of puts and calls. The
> theory is that the stock can't go both directions at once, so at
> least one of the options sold is gravy. The strategy is attractive
> at times of high volatility. Owning 300 shares, I might sell 3 calls
> and 2 puts so as to have a little cushion, the plan is if I am assigned
> on the puts I have the shares I own available to meet the obligation
> using margin. I agree about not using margin, but by matching the
> puts sold against shares owned it gets around tracking the cash used
> to secure the puts.
>
> On selling calls against LEAPS, it's a good strategy for what I think
> is a market bottom because it provides leverage. Using a stable,
> dividend paying stock, and buying the LEAP fairly far in the money,
> the time cost is not that great and can be recouped by selling short
> term out of the money calls against the LEAP. AN example of the
> type of stock I use for this would be IBM or JNJ.
>
Re LEAPs, I agree with your point re leverage in a bull market. I also agree with you regarding buying the LEAP deep in-the-money and selling the near-month call options. I'm less enthusiastic about targeting only lower volatility, dividend-paying stocks since (a) you are foregoing the dividend income by being long the LEAP instead of the stock, and (b) in comparing low and high volatility LEAP positions, the higher-volatility position is often more advantageous than the lower-volatility position because the higher monthly call option income obtained can more than offset the somewhat higher time value in the LEAP.
Adam -- Good points. I agree regarding the increased leverage with LEAPs, but the risk/reward profile cuts both ways -- i.e. increased returns on the upside, but also increased downside risk. Re using ETFs, (a) I don't understand your comment re "no security risk:, and (b) I'd rather buy DIA than a DIA LEAP since I prefer not buying an asset (LEAP) that loses time value (albeit slowly) and I prefer capturing the monthly dividend distribution from DIA vs. no dividend via its LEAP.
henarl -- I also consider dividend payments when analyzing potential covered call positions, but it often turns out to be a relatively minor consideration among all the factors that we consider. That is, there are added subleties with dividend-paying companies (that is both positive and negative factors to weigh in our decision-making process).
Glenn -- That's good common sense to me. As we all know, however, predicting bullish and bearish moves is a difficult undertaking -- but that doesn't mean we shouldn't try. So when my Overall Market Meter indicators are Slightly Bullish (as is the case now), I establish mostly slightly out-of-the-money covered calls. When slightly bearish, then slightly in-the-money covered calls, etc. etc. Just as you suggest!
Pablosba -- I do not favor setting stop losses. With wide intraday price movements, it is simply too common for a market maker to stop you out of a position via an inordinately sharp price bounce downward to fill your stop price. I would prefer you establish only a mental stop-loss price. Then follow your stocks prices daily and place a sell market order when you see that your stock has reached your mental stop-loss price.
Regarding getting called away early on dividend-paying stocks, I agree with you that this is often a very desirable result in terms of the good return-on-investment. On the other hand, if we would prefer to retain the stock to capture the dividend, it is easy for us to do that by ensuring that our strike price is either out-of-the-money or only slightly in-the-money (so that the time value remaining in the option is greater than the dividend payout amount -- in this instance, the call option owner has no incentive to exercise early).
Thank you all for your thoughtful and perceptive comments.
Regards and Godspeed,
Jeff
By limiting any sale of puts to cases where I already own the stock and keeping the ratio at one to one or less, I think I keep my overall exposure manageable. When doing what I think I should, I have about 10% cash and no margin borrowings. If the market tanks and I am assigned, I know I have enough collateral to pay for the additional shares and hold them if necessary.
On Jan 04 01:28 PM Roger Nusbaum wrote:
>
> "if I am assigned on the puts I have the shares I own available to
> meet the obligation using margin"
>
> assignment of puts results in buying shares, I'm not sure I follow
> what you mean about having the shares if assign on your puts.
Without recommending KO as an investment, which would you do?
Purchase KO at $45.90 (Friday 1/2/09 close).
Sell Jan $45 for $1.60 (in the money)
Sell Jan $47.50 for $.40
Sell Feb $45 for $2.65
Sell Feb $47.50 for $1.35
Sell May $50 for $1.65 plus $.38 dividend.
Sell Aug $50 for $2.65 plus $.76 dividend.
Sell Jan10 $55 for $2.10 plus $1.52 dividend.
Other, please specify.
Do you have specific 'return profile' rules? (i.e. at least 10% total return, 1% per month income, etc. that you're looking to achieve).
Thanks,John
All opinions welcome.
Thanks for your question. I prefer near-month covered calls, which in this case would be Jan09. The exception is when there is a week or less until expiration in which case I would sell the following month (Feb09 in this instance).
If you already own KO, I'd now recommend selling the Jan09 $45 strike. If you don't own it now, since I'm only neutral on the KO stock, I'd wait until the next quarterly earnings release in mid-Feb and then perhaps buy KO and sell the strike closest to the stock price at that time for Mar09 expiration. That way you have a good chance of capturing the ex-div (I think around 3/10/09) on the stock along with the call option time value premium.
I second the strategy on using the in the money (bearish) and out-of-the-money (bullish) to establish your covered call position.
Pray for a continued elevated VIX.
Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be is located at www.coveredcallcalcula...