Covered calls: An easy strategy to win
Today's Financial News - Posted November 19, 2008
The markets are unpredictable and volatile. Savvy investors are changing their strategies and pulling old tricks out of their tool bag. Try this technique to protect yourself from downside risk.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): When the financial markets are turned upside down and even the most well-educated of economists and investors cannot predict the next moves, investors need to take extraordinary action.
In typical economic environments, the vast majority of investors are plenty happy with the concept of buying low and selling high. Taking a long position in an equity is one of the simplest forms of investing.
Let me rephrase that. Taking a long position in an equity is considered the “easiest” form of investing. There are many other strategies that are equally simple, but few investors take the time to get to know their options.
Yesterday, I mentioned the fairly popular strategy options traders use to profit from volatile swings in an underlying stock, called a straddle. I have received feedback asking to elaborate on the technique and introduce a couple of straddle opportunities.
As an options guru, I relish any opportunity to share my knowledge. But before I tell you about straddles, there is another important topic, I want you to know about. With the market reacting the way it has this week and with options prices still ranging towards the outrageously expensive side, investors have a shot at much greater profits using a covered call strategy than they do with a straddle play.
Finding cover
You see, in a covered call, investors do not have to purchase an expensive options contract, they get to sell them. Right now, with implied volatility in record territory, few options provide the kind of risk/reward profile smart buyers are look for.
But high options prices create a great profit opportunity for covered call investors because they are the ones selling the overpriced options and banking the premiums as the contracts expire worthless.
This may sound confusing, but really it is quite simple. By entering a covered call position all you are doing is pre-negotiating a contract for the price you are willing to sell your shares and using the proceeds of the contract to protect your downside risk.
Think of it this way. You purchase an historic piece of art for $1,000. But you did not buy the artwork to sit on your mantle. You want to make money off of it. That means you eventually have to sell it. There is a chance that art will go down in value, but the odds are it will continue to go up.
Your neighbor knows you want to sell it, but he only wants the piece if it proves that it will continue to go up in value. So he says, “If the art dealer down the road says the painting is worth $2,000 or more any time during the next month, then I will buy it from you for $2,000.”
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You would be more than happy doubling your money in a month, so you agree to the contract. In exchange for giving your neighbor the right to buy the art during the next month, you charge him $300. No matter what, that $300 is yours to keep.
Now here is where the plan really gets useful. What happens if you are wrong and the artwork drops in value? It turns out the famous painter is not dead. He was merely hiding from his estranged wife in Portugal. The portrait is now valued at just $750. Obviously, your neighbor is not going to pay $2,000 for it.
If you would not have sold the contract to him, you would have lost $250 or 25% of your initial investment. But because you sold the option to buy the art to your neighbor for $300, you are still sitting on a profit of $50 (the original cost of the art minus the contract premium).
Are you starting to see how this strategy can be useful for equity investors? You can turn a major loss into a profit.
A real-world example
Imagine buying shares of General Electric (NYSE:GE) at their current price of $15.10. As volatile as this market is, a decline to recent lows of $14.00 is not out of the question. Prudent investors would cover themselves from this loss. That means they would enter a covered call position.
Take a look at GE’s options to see some opportunities. The company’s December 16.00 Calls (GEWLQ) are trading for $1.16. By selling these calls (which is just as easy as buying call options), you are selling the right for another investor to purchase 100 shares of GE from you at a price of $16.00 anytime before the options expire on December 19.
Even if shares suddenly soar to $20, you would still have to sell your stake for $16 like the contract states. At current prices, however, a sale at $16 would be a gain of just over 5% in less than a month. In today’s market, any gain is a win.
Now, what if GE’s shares continue to fall? By selling a call contract for $1.16 and banking that premium, you would maintain a profit as long as GE’s valuation stays above $13.94 (the purchase price of the stock minus the options premium). During this entire financial crisis, GE’s shares have not managed to dip that low.
So, if you were to simply buy shares of GE in a typical buy-low-sell-high strategy, you only profit if share prices rises. But if you enter a covered call position, you will win even if share price makes a 7.6% decline. In this market, I know which strategy I would pick.
Take advantage of this strategy
I hope the opportunities created by covered calls are starting to become obvious. While the strategy does limit your upside (in this case, you are forced to sell at $16 even if share price soars above it), it also greatly increases your odds of recording a profit because the premium you receive from selling the call options decreases your breakeven share price.
The markets are acting in strange ways. Old techniques and investing insight do not produce the same results they once did. By modifying your strategy just a bit, you can protect yourself from the downside and greatly increase your odds of success.
With options selling for huge premiums this is a great time to be selling calls. What happens when prices return to historic levels? That is when we move into straddle positions. I will spill my guts on that subject tomorrow.
For now, let me know your thoughts on these strategies. If you are confused or I need to clarify my thoughts, please let me know. I do not want you to miss out on these profitable strategies.
Next Article: Las Vegas Sands (LVS) in quicksand again
Posted by Andrew Snyder · Filed Under Investment Research, Investment Strategies
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November 20th, 2008 at 10:16 am
I am not clear Sir. Is this covered call strategy similar to short selling of stocks ? In short selling of stocks, you are actually selling stocks high and buy at low for profit. In covered call you do same thing with high priced call options ?
Thanks
Tejas
November 20th, 2008 at 10:29 am
thank you Andrew for taking the time to explain this strategy, i'm a bit confused though when buying a covered call are you banking on the stock to go up or down.
November 20th, 2008 at 11:08 am
Thanks for the comments. These are two very good questions. When entering a covered call strategy, you are buying a long position in an underlying equity and a short position in the related option. What that means is you are hedging your position. Ultimately, you are entering a long position, but not too long as you do not want the stock price to exceed your option's strike price. If it does, you are forced to sell your stock at the strike price and will miss out on any further appreciation.
There is often some confusion about selling options. When you sell an option, you do not have to buy it back to close the position as you would with a short stock sale. As soon as you sell it, the premium is yours to keep.
From there, one of two scenarios will occur. First, the underlying stock will not reach your strike price and the option will expire worthless (your most profitable scenario). Or the underlying position could reach above the strike price and the buyer exercises the option. When that happens, you will have to sell your underlying stock at the exercise price to the option buyer. At that point, the position is entirely closed and your profit would be the combination of the option premium and the appreciation of your underlying stock.
Make sense yet?
The only way you will lose money in a covered call strategy is if the underlying stock drops below the value that is your initial purchase price minus the premium of the call option. So if you buy a stock for $3 and sell a call option for $1, shares could go as low as $2 and you would still make a profit.
Let me know if this helps. This is a strategy everybody should be using right now.
November 20th, 2008 at 1:22 pm
Thanks for the comments. These are two very good questions. When entering a covered call strategy, you are buying a long position in an underlying equity and a short position in the related option. What that means is you are hedging your position. Ultimately, you are entering a long position, but not too long as you do not want the stock price to exceed your option's strike price. If it does, you are forced to sell your stock at the strike price and will miss out on any further appreciation.
There is often some confusion about selling options. When you sell an option, you do not have to buy it back to close the position as you would with a short stock sale. As soon as you sell it, the premium is yours to keep.
>From there, one of two scenarios will occur. First, the underlying stock will not reach your strike price and the option will expire worthless (your most profitable scenario). Or the underlying position could reach above the strike price and the buyer exercises the option. When that happens, you will have to sell your underlying stock at the exercise price to the option buyer. At that point, the position is entirely closed and your profit would be the combination of the option premium and the appreciation of your underlying stock.
Make sense yet?
The only way you will lose money in a covered call strategy is if the underlying stock drops below the value that is your initial purchase price minus the premium of the call option. So if you buy a stock for $3 and sell a call option for $1, shares could go as low as $2 and you would still make a profit.
Let me know if this helps. This is a strategy everybody should be using right now.