Monday, January 14, 2008

Cover your Calls and Sleep Well.

Trying to make money in this current market is a daunting, confusing task. The S&P 500, the benchmark index representing a broad scope of the market, is down over 10% since October and over 7% since the last two weeks of December.

Are we bottoming? Transitioning to a bear market? Is this a hiccup in the 5-year bull run? I surely don't know.

But I can recommend one strategy that can increase gains, lower cost bases, and minimize losses in a volatile, unpredictable market; write covered calls.

In this market, I like to use it to enter risky positions, in essence, at a lower entry-point. Here's an example of how to do that.

A year a go, Merrill Lynch (MER) was trading at $100; today it sits at $56. You believe that Merrill is a great company, and that it'll eventually get its act together. However, due to write-downs, the continuing housing crisis, and the possibility (or probability) of recession, you don't know if this is the bottom. But you would rather enter now than miss any upside.

A share of stock can be bought for $56. You go ahead and buy a lot of 100 shares for $5600. (We're excluding commission for this exercise; if you trade at a discount broker like Tradeking, commission is negligible anyway).

Cost= $5600

Right now, a contract of January 2009 calls at the $65 strike price is selling for $5. Once you own 100 shares of stock, you can write one contract of those calls that are "covered" by your shares (hence the term "covered calls").

If you go ahead and do that, you'll take in $500 right away. You can look at this money many ways; you can think the trade like you bought the stock for $51/share, or right now, your investment automatically made you 10%.

Here's the great thing about a contract like that; it's a win, win, lose-less situation.

  • Win: Say that the economic clouds blow over, and Merrill recovers to $75 next year. Your options will be called away, and your stock will be sold for $65/share, not $75/share. However, you still made a 30% return (20% stock move plus initial $500 credit for calls), only missing out on another 5% of upside.
  • Win: Merrill is approximately flat in 12 months. With the stock at $57, your gains would have been negligable just holding the stock, but by selling calls, you made a handsome 10% as the stock price remained stagnant.
  • Lose, but less: OK, this isn't the bottom. Merrill is $44 next January. But because you sold calls, taking in $500, your losses were less extreme than if you hadn't done so.
As you can see, the only bad thing about covered calls is that it can limit upside potential. However, as long as you have extra cash (or margin in your account), you can simply buy more shares if you like the company and your shares are going to get called away.

The amount of money you can take in depends on expiration and strike price. Sticking with this MER example, if you think that performance will remain poor, you could write Jan 2010s @ $65 strike and take in $8.30/contract, or take in the same $5/contract for the $75 strike price.

You can, of course, write covered calls on positions you already own, or as I displayed, they can be used to open new positions, too. Since the only shortcoming is the limitation of upside potential, it's a great time to write calls now as the market looks like it may move sideways, if not worse, in the near future.

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