newbie needs a critique

B

blackjack

I'm brand new at options. I've never made an option trade.

I need a critique of the strategy I'm considering.

It has "too good to be true" written all over it. I'm seeking to find what the catch is.

The strategy involves buying covered calls in an IRA account.

Sample scnario:

$5K in IRA.

Buy 100 shares of XYZ at $50 for $5K.

Sell a covered call at, say 7%, with an expiration in the following calendar month.

Get $350 for the covered call (7% x $5k).

Some possible outcomes.

1) Price stays near $50, and you get $350, or 7% return on your money, or 84% annualized. That is outstanding! Am I missing something here?

2) Price goes way up, and option gets exercised. You get $350 for the option purchase price, AND you get amount of money between XYZ at $50 and whatever price the option was exercised at. You get much more than 7% on your investment--perhaps, say 12-15%, or more. Again, that is outstanding! Who cares if the option purchaser made money? You certainly got your cut.

3) Price goes way down. Let's say XYZ crops to $12.50, or 25% of $50.

On the surface of it, it looks like you got badly hurt. But wait!

Yes, you lost $3750 of your stock's value. This was partially offset by the $350 you received for selling the covered call, so you are down $3400. You now have stock worth $1250.

Now here is where I am not sure what I am talking about, but I don't think you are in hot water in this scenario.

Here's why:

If I understand correctly, you may continue to sell covered calls monthly for say 5-9% or so of the value of the stock. Let's say you could sell a covered call for 7% of $1250 ($1250 being the value of your stock). That would mean that you would make $87.50 that month on your badly devalued stock, which had been worth $5000.

This is not shabby!

Reason: You will still be making a healthy annualized return on your original $5000. If you made $87.50/month selling a covered call on your remainining $1250, that would still represent 1.75% month on your original investment of $5000. Annualized, that would be 21%.

Hey, maybe you are used to triple digits, but for a very-bad-case scenario, 21% annually sure ain't bad! And for those who have been trained to think 10-15% in an IRA is about as good as it is going to get, this is great! And this is for a dismal scenario!

And the speed at which non-taxed IRA money compounds at 20% or more annually can be eye-popping compared to returns in the 10% or less range.

Tell me, what am I missing here? What is the catch? Why isn't everybody doing this?

Thanks in advance,

Blackjack



 
blackjack,
there are a couple things you are missing. Your strategy is basically the same as selling a put.

1. lets assume you owned something like CSCO. You may have captured some decent premium from selling the call but if you entered the position at the wrong time, the investment would have dropped over 50%.

2. You are assuming the volatilty or premium will remain the same month after month and thus you'll be able to capture the same premium month after month.

3. You are limiting your upside. Take the other side of something like CSCO. If you sold a covered call before the massive rally a few years back, you would have been stopped out with a relatively small return.

4. Re-investment risk. What will you do with your cash after you are stopped out? You are taking a monthly return and annualizing it. It's not that simple.

I can't say it's a bad strategy but in the end, you are capping your upside with unlimited downside (the stock could go to zero). If this is for a retirement account, you're probably better off holding on for the long haul unless you plan to really actively manage the account.
 
def, those are excellent points

I just wanted to stress that volatility plays a *huge* role in options. Anyone who is considering entering the options game should totally familiarize themselves with the greeks.

I would say that a short put or a covered call strategy (same thing) is only a good idea if the stock is in a nice uptrend (usually caused by a bull market!). Otherwise it is not a good idea for the reasons that def already mentioned.

btw short put is a more elegant way to play this as it involves only one transaction (and only one spread/commission).

read the thread 'selling puts' in this same board for more info on this
 
To add to what the others said, the reason why everyone doesn't do this is scenario number 3 you mentioned. First, when a stock drops a lot, usually the premiums for its options drop because of a decrease in volatility, so you wouldn't be able to get much anymore for the covered calls. Second, your math on this scenario is out of whack. You can't really consider it a "good" thing if your account started with $5K and now is at $1250, no matter what your percentage of return is. At the rate you described, you'd need 42 months, or nearly 4 years just to get back to your original capital amount. That's not smart money management by any stretch of the imagination.

The best play to do with options and stock that allows for decent upside while limiting your downside risk is an options collar. To do it, you purchase the stock, sell a covered call against it at a higher strike, then use the proceeds from the call to purchase a put at a lower strike. That way, you allow the stock to move up to the higher strike price, where if you are called out you make a decent profit. However, if the stock tanks you are protected by the put you purchased, which will increase in value as the value of your stock drops, giving you a net break even effect. Especially for a retirement account, this is a very nice strategy that gives you profit potential with safety.
 
I guess what it boils down to is that by buying covered calls in solid "reality-based" stocks (stocks that are not at all likely to go down to zero, and are issued by companies who sell boring things that people really need), even if the stock drops, say, 75% in value, you would be still be making (it appears) a good return on your original investment by consistently selling covered calls on the stock. (In the scenario I described a few posts ago, one would be making somewhere around 21%, annualized, on one's original investment, in the month immediately AFTER one's stock value dropped 75%! Wow! Of course, these numbers are just rough guesstimates, and I could clearly be unaware of some crucial information that I need to know about, so correct me if I am misunderstanding how this would work.

Also, it should be pointed out, what you would be making, annualized, in a given month, would clearly not be what you likely make, annualized, the next month--but the general idea is that you would be making a good--though fluctuating--rate of return even under some very bad circumstances. I define a "good rate of return" as being better than the standard 10-15% mutual fund-type rate of return.

If indeed, one's stock from which one is selling covered calls looked like it might be in danger going to zero, you could sell the stock at the next expiration date and invest the proceeds into a more stable-looking stock.

I will now address doing this IRA covered call approach in a bull market:

If your stock goes up and the option is exercised, it appears to me that you would make a VERY good return on your money for that month, with an entirely-possible 100+% annualized rate of return for that month; and with the proceeds of the stock sale, (and correct me if I am wrong), you could buy more stoc--(maybe a different stock)--and start all over the next month, and continue to make a very good return on you original investment as the bull market continued. From what I read, it is not rare to net 15% monthly on an exercised option. Annualized, that would be 180%.

What would further add to the appeal and stability of such a plan (again, if I understand this correctly) would be if you continued to add to your IRA more stocks over the years, and sold covered calls on those stocks. By buying a diversified basket of stocks for various sectors, and selling covered calls on them, you would be less beholden to the whims of the bears and bulls.

A key question I have is this: If you are buying stock and selling covered calls on it from an IRA and the stock is option is exercised, are you taxed on the proceeeds of the stock sale? Or are the stock-sale proceeds, and the option premium that you collected, safely under the tax-free umbrella of your IRA? (I believe that I saw a list of brokers who will allow options trading within the confines of an IRA--Dreyfus was one.)

Thanks in advance for any comments on this post, or the one about three posts prior.

Blackjack
 
Zboy2854a:

Nice reply. Really addresses where I am at in my learning curve.

I made the post that follows yours before I had read your post, so my apologies for that post not addressing what you had brought up in your post.

Thanks again for the feedback.

blackjack
 
Zboy2854a:

You had written:

"You can't really consider it a "good" thing if your account started with $5K and now is at $1250, no matter what your percentage of return is."

*********

Blackjack replies:

I don't think having a drastic drop in principal is invariably a bad thing, as long as your net interest income improves even as your stock-principal value drops, AND IF YOU NEVER HAD ANY INTENTION OF TOUCHING THE PRINCIPAL ANYWAY. (Reminds me of that saying of "old money": "Never touch the principal")

Certainly, it is not inconceivable that it could be better financially to have $1K in stock, than $4k in a standard 10-15% mutual fund. If the $1K is cranking out more income for you through the sale of covered calls, than the $4K would have in a mutual fund, and one's retirement nest egg is snowballing more quickly as a result, then I would think it better to have the $1K from a retirement standpoint.

From an interest income standpoint, certainly, making 60% annually on $1K of stock holdings from the sale of options on the holdings, is better than making 10% on $4K invested in a mutual fund. ($600 versus $400 annually.) You're spendable retirement nest eggs would snowbal more quickly with the $1K in stock than with the $4k in cash.

Again, the key to all of this is having no intention of selling or spending the principal.

This reminds me of farm fields. If one had a 40-acre farm field cranking 1000 truckloads of crops annually, and traded it for a smaller, 10-acre farm field cranking 2000 truckloads of crops, that might be a good deal. Who'd care if you'd end up with a smaller farm field?

Now, if you were planning to SPEND your principal in your retirement, or SELL you farmfield when you hit age 65, that would be a different matter entirely...

********

If the above is true, that doesn't mean that the above cannot be improved upon, and I am very receptive to your suggestions in your earlier post about puts, and I shall read up on that, immediately.

***********

I had an idea as I typed. Let's say one's $40 in stock had tanked to $10, and the percent rate of return on selling covered calls on the stock had become quite unattractive becuase the stock was not at all volatile. It would seem one would then just want to sell the stock and buy another of the same approximate price but with with greater volatility and having covered calls sellable at a higher price. This would be a way out of being stuck with a badly-devalued stock that can't crank out good option income anymore. Any comments?

thanks,

balckjack


 
blackjack,
here are a few practical points i thought of..
1. stable stocks usually do not offer high premiums for selling calls.. i haven't looked into it for a while, but as i remember, you can expect <1% to maybe 3% for "safe" stocks. to get the higher premium you have to buy a volatile stock, which is more likely to lose a lot of value.
2. after the stock drops say 50%-60%, and the volatility collapses, and you can't get any more premium for selling calls, you said you can buy another stock with higher volatility. well, the stock that dropped has low premiums because it is now *stable*. by switching to a different stock with higher volatility you are now exposed to the possibility of a similar drop, which is what got you here in the first place! a few unlucky months and you are out of the game with 15% to 25% of your original investment.

as for other ideas, some people mentioned selling puts, and i agree that selling puts has the same risk/reward profile as covered calls.. i would suggest selling credit spreads instead. sell a put, and buy a lower put to reduce the risk. now, with that 5k, instead of buying one stock you can sell credit spreads on 5-10 different stocks and spread out your risk. the main problem here is wide spreads and high commission costs.
 
blackjack,

It seems to me you've become too caught up in "percentages" rather than actual balances. In the original scenario you painted, you started with $5K, went down to $1250, and generating the monthly "percentage" return you described would need 4 years just to get back to your original balance. While 21% annualized is great, all that "interest" is simply working for 4 years(!)to get you just back to breakeven in your account. And this also assumes that you are able to generate the same percentage every month and are not called out, etc. The other big factor here is that if your capital has been reduced by 50-75%, your choices of stocks to purchase have automatically reduced greatly, thereby greatly reducing your chances of getting into the stocks that you want. There are so many variables that it's not realistic.

However, as I mentioned in my other post, seriously look into options collars, which will basically give you at best a decent monthly return like you are looking for, and at worst give you no drawdown or loss for the month if your stock tanks.
 
Everyone:

Thanks for your input and feedback as I slowly become more educated in this interesting subject of options.

Here's a scenario I now am trying to find the flaw in:

1) Buy 100 shares XYZ at 50, for $5K.

2) Sell a covered call for a given premium with an expiration date in the next calendar month.

3) Simultaneoulsy buy 100 shares XYZ short, using a different broker if necessary (in case the original broker won't let you buy a stock long and short at the same time).

4) If the option is exercised on the stock that you sold the covered call on, sell the short at the same time. The long position and the short position will cancel, and you get the premium (minus commissions and possible slippage and spread). Hopefully, you could find a way to have this simultaneous sale be done by computer. Also, it would be a great idea to buy a highly liquid stock with a history of very small buy/sell spreads.

5) If the option expires unexercised, sell the long and short position simultaneously on the expiration date. The long and short will cancel, and you will get the premium (minus commissions and slippage).

*******

A improvement upon this strategy might be to use a direct access broker to sell the positions on the date of expiration.

One could select a moment where the stock price is moving briskly in either direction, and use that moment to unload the stock that is losing value, while retaining ownership of the the other stock that is gaining value, until the price movement begins to die down. In other words, use a day-trading scalper's approach to unloading the stocks.

Example: On the option expiration date, the price of XYZ is 46, down from 50, and your original purchase price of your long and short positions in XYZ cancel each other out.

Instead of automatically and simultaneously liquidating your two opposing positions, you wait until, say, the price of XYZ is starting to uptrend from 46 to 46.05...46.10... You use standard scalping techniques to determine when this moment is likely to be occuring.

At that moment of a likely continued upswing, you dump your short position, and retain your long position. If you are a competent scalper, you will be much more likely than not to avoid losing a needless money on your short position, while allowing your long position to complete an upswing of a fraction of a point or more.

Done routinely, this could be represent a significant second profit source. If you could average, say, an extra quarter point every time you liquidated your positions, that would be an extra $25 bucks per 100 shares in the kitty. If your option premium had been, say $500, or 10% of $5K, that would be like getting $525 instead of $500, or 10.50% instead of 10%.

If your option premium had been lower--say 5%--then the extra quarter point, or $25 per hundred shares, would loom larger as a percentage of final income. In the case of a 5% premium, your effective premium would average 5.50%, which would be a 10% increase in your original 5% premium.

*********

It would appear to me that this scenario of simultaneouly buying a short and long position, and then selling covered calls on the long position, would perhaps be one where you would HOPE the option was exercised early so you could repeat the process again for the same one-month cycle.

I could see where on might get real good at selecting stocks that were likely to hit the exercise price quickly, and be able to sometimes "turn around" this arrangement a number of times in a given month, in some cases.

********

Again, I'm a options newbie, and, to paraphrase Ben Franklin, I am seeking to have my "theories murdered by a gang of brutal facts."

I extend an open invitation to anyone wanting to join a theory lynch mob :0)

Thanks in advance for any feedback,

Blackjack

 
You must log in or register to reply here.
Back
Top