Advice when selling covered calls, in or out of the money?

[thwang99]

Hi all,

For those of you who try to generate income from covered calls, do you sell in the money or out of the money calls?

I've recently started setting aside some funds to try this, with a goal of generating a return of 20-40% per year. I try and find stocks where selling the covered calls generates 10-15% in 2-4 months. When doing this, what should I look for?

Should I only sell to open in the money or out of the money calls? In the money has the benefit of providing some slight cushion in case the stock falls. Out of the money has the potential for some small capital gains if the stock rises in price.

Anyways, hopefully someone out there uses covered calls as part of their strategy and can help me out here! /images/graemlins/smile.gif Thx in advance.

- Tony

[RocketManJames]

Sure sounds like you're going to be selling calls on stocks with HIGH volatility. To achieve the 20-40% per year you are after, you'll need high volatility.

Also, I think what you're planning on doing is high risk. If you are purchasing a stock only because you want to sell the calls, then you're really putting a lot at risk. If you've already got larger holdings and you're trying to enhance overall yield, then covered calls, imo, is a viable option.

As for the option parameters you're looking for... I can't really help much there.

-RMJ

[goodedesign]

[RocketManJames]

[ QUOTE ]
i did a trade like this on HOV 2/26... I bought 1000 HOV for 74.5, waited til 3/8 when HOV was at 90.22 and sold the feb 75.00 calls X10 for 15.20 (15,200) selling for 75 what i bought for 74.50, with a 20% return UP FRONT for the MONTH.

and my goal was 5%/month...

[/ QUOTE ]

Maybe I misunderstood what you wrote... but how does that make any sense? You bought a stock at 74.50... good stock pick, it runs up to 90.22. Why would you bother selling the Feb 75 calls for 15.20? Why not just dump the stock? How are you any better off selling the options? What is the point of selling options that have no time value? The intrinsic value of the option is basically 100% of its worth at that point due to it being so deep in the money.

Also, what would you do if the stock hadn't run to 90+? What if it had fallen to 65?

And, it doesn't take a Rocket Man like me to know that 5% monthly return is not achievable over long stretches of time.

-RMJ

[goodedesign]

[RocketManJames]

You missed my point...

If you buy stock at 74.50, and it runs to 90.22. Why would selling covered calls for 15.20 be *better* than simply selling the stock?

Ever notice that volume on deep in the money calls is usually pretty small? Is that because it makes more sense to simply sell the stock, since the call no longer has any time premium? Deep in the money options, from what I've seen is used as a way to obtain greater leverage than margin would normally allow, but that's on the long side, and not something I recommend.

You say that you've ensured profit? No, you haven't. Selling the stock, you'd have profited (excluding commissions and fees) 15.22/share. Selling the calls, you've "locked" yourself to 15.20/share (excluding commissions and fees)... BUT, you haven't ensured anything 100%. If the market were to melt down, and the stock plummets, you could still lose money. What's more is you have ZERO reward compared to simply selling the stock. If the stock went to 400 you'd profit the same in both scenarios. If the stock went to zero... you've ensured precisely nothing with selling deep in the money covered calls, but with sold stock, there would be no effect on your profitable trade.

Ok, now tell me again...

Why is selling the call for $15.20 better than simply dumping the stock?

I never claimed to be an expert on this, and in fact, I learn something new each day. But, I really hope that those who are less in the know don't follow your strategy blindly, because you're NOT making 3% per month compounded over any real stretch of time.

And, if you sat next to Buffet, he'd probably break wind in your direction.

-RMJ

[goodedesign]

[RocketManJames]

[ QUOTE ]
benefit: you have choices when you sell the option... the money comes into your account immediately... yet you still OWN the stock... if the price of the stock falls, you can buy back those options, and then resell them for a profit again in the future... thus, effectively PRINTING money out of the stock.

[/ QUOTE ]

Uhhh...

First off, the only reason you were able to book such a "large" gain from selling the option is because the stock ran up over $15 from your purchase price.

Now, you say that if the stock drops you can buy back the options and do it again. If you sold the stock, you'd simply buy the stock back if it dropped. And, if the stock dropped, you'd be buying back the options with a time premium now attached to it (for those who are new to options, an option's time value is larger when it is near or at the money than when it is deep in the money). So, effectively, you've done WORSE than simply selling the stock. Not to mention higher transaction fees.

A big problem is that you're doing all this hand-waving about how you made so much from selling calls, but really... where did that profit come from? It wasn't from the calls... it was from a stock that ran up over $15 for you.

You have a serious lack of understanding. And, I can't wait until you get a few blind followers who are awestruck by your market prowess. Because, then you'll have set them up perfectly to sell the "Goode system" -- 3% monthly returns -- If you're not satisfied, don't worry, you'll have a 30-day risk free money back guarantee.

-RMJ

[DesertCat]

[ QUOTE ]
you ought to here the techniques i use that buffet does...

[/ QUOTE ]

It's amazing how stock market charlatans like to throw around Buffett's name to give their silly ideas the patina of authenticity, even when they run directly counter to every piece of advice Buffett has ever given. Goodedesign is trying to make money off of 2+2ers by selling a "trading system", when Buffett has consistently advised that trading is bad, will hurt your results and is the road to ruin for small investors. Hmm, who would you believe? A guy who draws logos (probably in crayon), or the most successful investor of all time? One clue, Mr. logo doesn't even know how to spell "Buffett".

[goodedesign]

[DesertCat]

I don't care how you invest your own portfolio. What irks me is that you are trying to use Buffett's name to justify your techniques, when they run counter to all advice Warren E. Buffett has ever given. WEB specifically has said that trading is bad, and that Technical Analysis and charting are worse than useless. WEB would absolutely puke if he read any one of your posts.

Also, for the second time, I'm requesting that you please document for me any time in which Warren Buffett has said he uses a technique called "sweeping the change". I've spent a great deal of time studying Warren and his philosophies, and have never come across any such reference. The core principles on which his fortune has been made are simple, clear and have very little to do with covered calls or trading.

So go ahead and continue to gamble with your portfolio until that day it melts down completely. And if in your blind enthusiasm you must to encourage others to risk their portfolios similarly, go ahead. But stop trying to fool people that the hokum you espouse had anything to do with Buffett's success or is in any way used or endorsed by him.

[goodedesign]

[DesertCat]

I can't reply to your private message, the system says you aren't accepting any, so I will just reply here.

[ QUOTE ]
ok.. the method i use that is EXACTLY like buffett: SWEEPING THE CHANGE

you own a stock and get paid for owning it...

each month a week or 2 b4 expiration, (here i have to know which way the stock i hold is going), then sell out of the $ calls for this month against the stock that you are buying/holding... i do this and expect NOT to be called out of THIS transaction... ...

[/ QUOTE ]

I'm not telling you that covered calls can never work. You earn money by taking the risk of being called out of your position. If the stock isn't volatile, you won't earn much, but you'll be safer.

I've never heard WEB say he's used covered calls in this manner. In WEB's case, he has alluded to using options to enter or exit positions when the price wasn't yet at his target. This isn't a free lunch either, because it can tie up your portfolio when other opportunities arise.

[ QUOTE ]
i've studied him too, and there was a period of time that all of his portfolio stocks were flat to down, yet his net worth doubled!

[/ QUOTE ]

I'm not sure what period you are talking about, but you can probably attribute that to "special situations investing" or arbitrage (what I do all day long). WEB has consistantly engaged in arbitrage investments to provide portfolio growth when the market is unattractive.

In addition, most of Berkshire Hathaway is made up of privately owned businesses that contribute their excess profits to Berkshire, for example Dairy Queen annually contributes something like $100M to Berkshires net worth.

Lastly, WEB does occasionally use options. He's very aware of how they are priced (by Black Scholes) and how that model leads to pricing inefficiences. So he does pick up spare change there occasionally. He's also invested in silver and most recently, foriegn currencies, when he felt they were undervalued.

But every one of his transactions is done around the basis that he is able to estimate intrinsic value for the investment, and buys it when it's substantially undervalued. That is the basis of 99% of his wealth.

[ QUOTE ]
sweeping the change: i found that in a book, i'll get back to you on what book it was.

[/ QUOTE ]

Once again, please do. It's like you met some guy in an alley who hissed at you and said "I've got some info on Warren Buffett for you." All of your information is wrong, it's counter to what is commonly known about WEB and his investing. I think your "mentor" like most investment charlatans was eager to attach WEB's name to his techniques to lend them legitimacy.

I've actually been to the BRK shareholder meeting, where he answers questions like this for 8 hours, and at the meeting I attended, and the dozen or so I've read transcripts from, never mentioned "sweeping the change" or covered calls.

WEB is rich because he bought low and sold high. It's as simple as that. I suggest you go to the Berkshire Hathaway website and read his shareholder letters (they go back to the mid eighties). They will not only teach you a great deal about investing, but they're also pretty entertaining. I recommend them to anyone interesting in finding out the true methods of the worlds most successful investor.

Berkshire Hathaway (http://www.berkshirehathaway.com)

[DesertCat]

Once again, I can't reply to your PM's since your account doesn't accept any, I have to reply here.

[ QUOTE ]
now this is NOT advise... i bet WEB might have sold calls on KO about 3-4 days ago and gotten @ $0.15/share on as many as possible... and he will still own the stock, and he'll get .15/share. and then he'll buy MORE of KO when it's on sale ready to go up.


[/ QUOTE ]

Next week's $45 call options are selling for 5 cents on extremely low volume (572). Berkshire Hathaway owns 200M shares ($8B) of Coke. Even if he accounted for all of todays volume it wouldn't be worth worth the time it took for him to have that thought.

If volume wasn't a consideration, he's still taking a risk of being called out of his position. That's ok if he really wants to sell at $45, if once in a blue moon KO shoots up to say $47 on expiration, he lost 1.95. So if you want to gamble here you have to be very confident that your loss will happen less than 1/40 times. Worse case is if you think KO is worth much more and want to hold it. That risk of being optioned out now triggers capital gains taxes, which in Buffett's case would be close to $10 per share. And worse is that repeatably getting optioned out within a year would kill your long term capital gains, and force you to immediately pay much higher short term capital gains.

[ QUOTE ]

earlier in the year (Mar) WEB was asked what stock he was buying... he said that there wasn't anything in the market worth buying... on the other hand... come around Aug-Sept... he had a few billion $ in cash waiting to dive back in.


[/ QUOTE ]

Not exactly true, he's been saying the market is too expensive for years now. Buffett actually has had over $30B in cash and cash equivilants sitting around waiting for opportunities for the last couple years. Berkshire has a net worth of over $100B. Unlike you and me, he needs to find investments liquid enough to put $10B or more to work nowadays, and it's getting pretty damn hard. It's one reason why his days of consistently beating the S&P 500 like a drum are probably over.

It's not for lack of ability, he's sharper than ever. While he's been waiting he put around $20B or so in Forex, betting against the dollar. I think he's up a couple billion on that one. A couple years ago he spent 6 months in the high yield market when it got too cheap, and made a couple billion there. Keeps him out of bars, as his partner says.

When you see his name attached to sub-billion dollar investments it's usually either Geico's investment manager (who is forced to report under Berkshire's name) or sometimes his private portfolio, which is a few hundred million he devotes to high yield and arbitrage investments to ensure he has a steady income for walking around money (Berkshire only pays him a $300k or so a year).

[goodedesign]

[DesertCat]

[ QUOTE ]
not a bad days work if you ask me. and he'd most likely KNOW that he wouldn't lose his shares because he's owned coke almost before coke owned coke.

[/ QUOTE ]

I'm getting the strong feeling that you've only been investing for a very short while. Long Term Capital Management collapsed, losing billions of dollars because they had decades of stock and bond data in their computers that proved to them that the prices wouldn't have sudden, divergent moves and bankrupt them. Whoops.

Warren doesn't use technical indicators, because he doesn't believe anyone, esp. himself can predict short term price movements. He understands how options are priced, and in your example there is still a real risk of being optioned out of his position.

For example, if WEB had been regularly using your techniques throught his career it is a virtual statistical certaintly that much of his long term capital gains (he has some over 30 years tax deferred) would have been converted into short term, immediately taxable gains. And his net worth would be a tiny fraction of what it is today.

[DesertCat]

Also, why don't you read up on Buffett before you try to make definitive statements on him. For example he hasn't owned coke "almost before coke owned coke". He bought his first shares in the mid-eighties, so actually it's one of his newest positions. He owned Pepsi shares before that.

I highly recommend Roger Lowenstein's "Buffett: The Making of an American Capitalist".

[FatOtt]

Buffett has been a director of Coke for about 15 years now. You think maybe, if he was doing all those trades you claim he's doing, that maybe he would be filing documents with the SEC? Maybe?

p.s. - He's not doing those trades.

[GeorgeF]

FWIW selling a covered call, with a strike at $75 on a $90 stock cuts off all possibily of gain if the stock closes above $90. If the stock drops below $75, or so(*), you still loose.

(*) actually $75 - price of covered call.

You also loose use of your money until the option expires (or you sell the stock). Probably not a big deal at 2% to 4% interest rates.

[goodedesign]

[Paluka]

I just wanted to make sure that everyone reading this forum realizes that this goodedesign guy is a joker of the highest degree. Most of his posts regarding options are gibberish.