Apple, Silver, Ralph Lauren: Getting Burned By 'Conservative' Trades

Includes: AAPL, AGQ, RL
by: SA Editor Rocco Pendola

I have sent out a pair of covered call trades to subscribers of my stock option investing newsletter that have (or appear to have) gone off quite nicely in recent weeks. As I was reviewing those, I thought about the Apple (NASDAQ:AAPL) bear call spread, which backfired on me, that I wrote about on Wednesday.

You can read the details in the article, but, in a nutshell, going into that AAPL trade, I considered it a pretty conservative move. It was a bear call spread that would have been just fine had AAPL not blown the doors off of the stock market over the course of two weeks. It's probably a trade I would have only made in a simulated account, but, nevertheless, I thought the credit I received from it was money in the bank. That's a lesson learned in and of itself.

That experience got me thinking about covered calls. Most options types consider covered calls a relatively conservative strategy. Generally, I would agree, but the one thing I stress when I review prospective trades is that you should not enter a covered call, particularly a buy-write (where you buy the stock fresh alongside writing one or more calls), unless you have a bullish near- to long-term view on the stock or ETF you're dealing with.

To the right you see a review of a trade I sent to subscribers several weeks ago. It's a buy-write involving the ProShares Ultra Silver ETF (NYSEARCA:AGQ). This ETF returns twice what silver does (to the up or downside) on a daily basis, therefore it's not meant as a long-term hold. I consider it a trading vehicle or an ETF to hold for weeks or a couple to a few months at a time. I have had great success writing covered calls against these leveraged ETFs during times when they are volatile.

Because I believe in the bull case for silver, I have no concern being long AGQ through March. Wednesday's dive in silver actually put a smile on my face. I expected Thursday's bounce. It's the type of volatility I anticipated and it's what makes buy-writes with these ETFs at the right time the gift that can keep on giving.

That said, this type of covered call, granted, ranks higher on the "risk scale" than a standard old buy-write and/or covered call on a run-of-the-mill stock. Even so, both trades share the same fundamental risks.

This past week, I made the case for buying Ralph Lauren (NYSE:RL) under $175 and selling either the RL March $180 call for $1.45 or the April $180 call for $4.30. At this point the trade looks good. Ultimately I want the stock to rise past the strike at expiration, which would result in the call holder taking my shares of RL from me.

If this happens you turn a 4.5% profit in the March $180 scenario and a 5.9% profit in the April $180 scenario, assuming you bought your RL shares for $174. In both the AGQ and RL cases, the lesser of two risks is that the security blows past and closes way above your strike at expiration. You left money on the table because you locked yourself into a fixed profit by writing the covered call. But that's part of the game and a disciplined investor should not fret over this.

The bigger risk, however, is seeing the underlying security tank. You start losing money, using my prices, on the AGQ trade when the ETF trades below $56.38. In the RL examples, you start losing money at $172.20 on the March trade and $169.70 on the April transaction. You can easily get to that number by subtracting the credit received from your entry price on the stock.

Before entering a buy-write, you have to ask yourself, would I be OK owning AGQ at $50 or RL at $160 or, for that matter, anywhere below my breakeven. With AGQ, you would need to be particularly careful because of the volatility and the risks associated with its replication of daily performance. With RL, you would just need to make sure that it's a stock you would not mind owning for the long haul. Of course, you could be just fine taking a loss and living to fight another day, but that's not an easy pill to swallow for many investors.

Disclosure: I am long AAPL, AGQ, RL.

Additional disclosure: I hold covered call positions in AGQ and RL with March $64 and March $180 strikes respectively.