Covered Calls: Steady Gains With Protection

|
 |  About: DryShips Inc. (DRYS)
by: John Dalt

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?

Craps Layout 7 come 11Click to enlarge

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 most of the money whether the buyer wins or not.
Click to enlarge

Let's say we bought DryShips (NASDAQ:DRYS) for six dollars 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 DRYS 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 biggest 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.

Disclosure: Long DRYS