Why Covered Calls are Safer than Buy-and-Hold?
Most people consider their retirement account to be the place where they exercise the most restraint and utilize only the least risky investing strategies. They don’t want to take any chances with their retirement funds, but they do want to make sure the account grows. And for them, buy-and-hold is the safest strategy of all.
However as many individual investors discovered during the recent economic recession, buy-and-hold does not guarantee that you will not lose money. They were shocked and appalled to find out just how much they could lose when the stock market fell by over 50% in 2008 and early 2009. Those that stuck it out and held on have recovered well, but those who decided to get out of the market ended up locking in their losses.
As a matter of fact, there is only one way to absolutely, positively guarantee that you will not lose money when you buy stocks. It is so safe that it is approved for use in an IRA or a 401(k). And, this strategy actually protects against the downside that you are exposed to when you own a stock, so it’s actually safer than holding the shares by themselves.
And yet, because it involves the use of options, most investors dismiss this strategy immediately, without learning anything about it, because they think it must be risky.
The safest strategy of all involves holding shares of stock, and selling (writing) covered call options against those shares. A call option means that you are selling the buyer the right to buy your shares at a particular price (the strike price) on a particular date (the expiration date). A “covered” call means that you already own the shares; a “naked” call, on the other hand is much riskier, and means that you do not own the underlying shares.
Scenario One – Holding Stock Alone
For example, let’s assume you were holding 100 shares of Microsoft in your IRA in January 2008; the stock was trading at approximately $28 per share. By February 2009, it had dropped to $14. If you were a buy-and-hold investor, your portfolio just suffered a decrease of 50%.
Of course, if you managed to shake off the fear and hold on, your shares had recovered by January 2012. But that was a long three years to wait and hope that the stock would rebound.
Scenario Two – Holding Stock Plus Writing Covered Calls
In Scenario Two, you own 100 shares of Microsoft, but you also write covered calls against your shares. Again, in January 2008 the shares are priced at $28, and you sell a three-month call option with a strike price of $30; that is $2 out-of-the-money (that is, priced higher than the current stock share price). (I’m going to make a lot of assumptions here, because I don’t have access to the historical options price data.)
You sell the call in January, and it will expire on the third Friday in March. Perhaps you obtain a premium of $1.00 for this option, which translates to $100 ($1.00 x 100 shares) into your account.
That $100 is yours no matter what happens afterwards. In effect, you have just secured yourself a $1 per share profit, which also acts a cushion against the stock price dropping while you hold it.
In fact, the share price DID drop, and by the expiration of your call in March, Microsoft’s price was down to $25, so the buyer was not able to exercise (buy your shares) and the option expired worthless. You kept your shares, and you could then turn around and sell another call.
If you repeated this multiple times during the course of 2009-2011, you could have made a substantial return, even while the price of the stock was down dramatically.
Conclusion
It’s worth noting that about 95% of all options expire worthless. This fact puts the odds greatly in your favor if you sell calls; if 95% of them expire worthless, then only 5% are ever exercised. That means that, if you plan your trades carefully, you have a 95% chance of earning the premium on the call AND keeping your shares.
Understand, also, how this strategy is safe; you can literally NEVER lose money by selling covered calls. In the worst case situation, the price of your underlying shares increases and your option is exercised; in that case, you keep the premium and you have sold your stock at a higher price than when you sold the call.
There are a lot of complicated calculations that can go into determining exactly which calls to sell and when, so if you really want to get involved in this strategy, you should look to an expert for help in making these decisions.
CompoundStockEarnings.com is an excellent site to help with your analysis. The service can help you learn to generate profits in the range of 3 to 6% per month, which can compound to an incredibly dramatic overall return. They offer free live seminars and trial memberships, to help with your education.
Category: Investing
