Covered Calls

[xprinter]

My financial advisor is in a group at a large Investment Firm. Two advisors and one technical person are in his group. My simple IRA, Traditional IRA, Roth IRA for my wife and I, and a taxable account. Since joining this group a year and a half ago my advisor has invested in covered calls. They believe that this is the safest way to be in individual stocks offering me some protection on the downside while limiting large gains.
I would like some advice on what others feel about my advisor's system? If anybody wants my specific investments I will list them in another post. Over the past 9 months I was ahead, but the last two weeks have been down big time.
I forgot to add. The yearly cost of the advisors is 1.1%

 

[JPatrick]

I guess the first thing you ought to find out is how much all this action is costing you.
If you are saying that you are down for the "year "as of the last two weeks, then I really think something is wrong.  The averages are down for the year, but a pro should have been able to keep your head above water.

 

[haha]

The profit/loss picture for covered calls is that you have an open ended loss in the case of decline, but a truncated gain in case the stock price increases. It is a winner in times of limited volatility. Limited volatility pretty well describes this past year. So if your guys can't make you any money in these circumstances, you will likely be annihilated if we get some downside volatility.

Oh yeah, there are lots of other reasons for an investor to dislike this strategy as well. But it is a really good one for the broker. Lots of fees, and most of the time the client survives.

From the broker’s POV, the client in this strategy is like a cow in a Masai herd. A bit of regular bleeding which is only occasionally fatal.

Ha

 

[xprinter]

So what would you recomend I do at my annual meeting later this month?

The profit/loss picture for covered calls is that you have an open ended loss in the case of decline, but a truncated gain in case the stock price increases. It is a winner in times of limited volatility. Limited volatility pretty well describes this past year. So if your guys can't make you any money in these circumstances, you will likely be annihilated if we get some downside volatility.

Oh yeah, there are lots of other reasons for an investor to dislike this strategy as well. But it is a really good one for the broker. Lots of fees, and most of the time the client survives.

From the broker’s POV, the client in this strategy is like a cow in a Masai herd. A bit of regular bleeding which is only occasionally fatal.

 

[xprinter]

Here are most of my stocks. (BE EMC IGT SBC VZ MO BAC CHKP SNDA TEVA TOT SBS AC MOT PFE TGT SFL)

 

[haha]

Sorry, I am not in a position to comment on your specific situation. If you have any questions about the covered-call profit matrix, I or any one of a number of people here can probably add a little.

You didn't say if you pay 1.1% plus commissions, or 1.1% total including commissions. Options are a high cost game, even without commissions, because of relatively high spreads and slippage.

I feel that you should at least invest in a good basic academic options book so you can understand what is being done.

Ha

 

[brewer12345]

xprinter, the basic problem is that you don't understand what is being done with your money. If I were in your shoes, I would read up before your meeting and be ready to have a frank discussion with the advisors about costs, volatility, downside risk, etc. I personally do not bother with covered calls in part due to the costs involved, but some people seem to have success. You need to make a decision and you need to be educated enough to make that decision.

 

[ERD50]

xprinter, FWIW, I think that Haha and brewer make good points. I am a bit more positive on Covered Calls, I think they can be a good strategy under the proper conditions. But, your advisor might be using them more to line his pocket than yours. I would definitely follow up on the question - does the 1.1% fee include the commissions?

I am currently up 10% over the market with a CC strategy. But I do a bunch of research each month - I doubt an advisor can spend that much time on it - but maybe. As HaHa said - during times of limited volatility, it can be a winning play. In fast bull markets, you will limit your upside. In down markets, it can help cushion the blow.

-ERD50

 

[xprinter]

Thanks Erd50, I was looking at my 12 month returns and I am up about 3 percent year to date. Then I looked at some mutual fund groups (Vanguard, Fidelity and TR Price). It seems the only fund groups that are up significantly year to date are the foreign funds. Other that them most funds are average 2 percent up - 2 percent down. Maybe I am not doing so bad with my adviser, I probably would not do any better on my own. I noticed the Rydex Juno Fund that I have a small investment has been a real dog. This fund reacts inversely to 30 year treasuries, but I noticed a huge expense ratio over 2%. I think that I would rather have a gold position instead.

 

[pagar]

I'm looking for solid dividend paying stocks. If I looked at BAC and decided to add it to my holdings tomorrow. I would probably buy it in the $41.50 range. It is paying $2.00 per yr div. Looking at the overall market for the next few quarters, it looks like the stock will trade in a pretty narrow range or even drop a little. To increase my earnings, I look at the
covered calls. The Jan07 $42.50 strike has a $2.75 bid. My broker charges $15 to buy the stock and $15 to write the call. The dividend to be paid for the quarters to Jan 07 is $2.50 The premium paid immediately when the call is written is $2.75. If I just hold for the dividend, the expense is $30. If I spend another $30 I double my return.
If I want to increase my dividends received to $400; Just by owning stock, I would have to put out another $4150.00. By using the covered call method I can double the amount received by paying another $30.00 fee. I prefer covered calls.

 

[JPatrick]

I'm looking for solid dividend paying stocks. If I looked at BAC and decided to add it to my holdings tomorrow. I would probably buy it in the $41.50 range. It is paying $2.00 per yr div. Looking at the overall market for the next few quarters, it looks like the stock will trade in a pretty narrow range or even drop a little. To increase my earnings, I look at the
covered calls. The Jan07 $42.50 strike has a $2.75 bid. My broker charges $15 to buy the stock and $15 to write the call. The dividend to be paid for the quarters to Jan 07 is $2.50 The premium paid immediately when the call is written is $2.75. If I just hold for the dividend, the expense is $30. If I spend another $30 I double my return.
If I want to increase my dividends received to $400; Just by owning stock, I would have to put out another $4150.00. By using the covered call method I can double the amount received by paying another $30.00 fee. I prefer covered calls.

Just a couple of thoughts.  I don't know when the div is paid, but if it is anywhere close to the strike price and the stock is too, you may lose your stock before the div is paid.  Also, the commission to sell your stock,  if it is called,  will likely be higher than the normal buy/sell commission.  You should find out. Of course, all you have mentioned (except the div) will not get a favorable tax rate.  If you are going to do a lot of this type of investing you should look to a deep discount broker so you can cut your commission in half or so. Lastly,  I believe BAC announces earnings tomorrow, so you may want to consider  that before you leap.

 

[pagar]

Just a couple of thoughts. I don't know when the div is paid, but if it is anywhere close to the strike price and the stock is too, you may lose your stock before the div is paid. Also, the commission to sell your stock, if it is called, will likely be higher than the normal buy/sell commission. You should find out. Of course, all you have mentioned (except the div) will not get a favorable tax rate. If you are going to do a lot of this type of investing you should look to a deep discount broker so you can cut your commission in half or so. Lastly, I believe BAC announces earnings tomorrow, so you may want to consider that before you leap.

A. Discloser- I am not buying BAC today.
B. Early assignment is a risk with American style options, but I don't see that as problem. With a $41.50 purchase price and a $42.50 Strike, there is a $1.00 improvement by the option being assigned early; therefore I do not see the loss of a fifty cent dividend as a problem.
C. I check fees when I switch brokers, when they get too high or the service declines I switch again. My broker charges the same rather its a stock sale or an option excise/assignment. The $15 stock
purchase covers up to 1000 shares. The $15 option write covers up to 10 contracts. There are lower fees available, If you meet the active trader rule. Since I never intend to be an active trader, I will never qualify.
d. Since the market puts a strong message to companies about earnings annoucements/expections, earnings release dates may be a good day to purchase, or not. But the very little research I had done before I posted last night clearly pointed out that today was earnings release date for BAC.
e. The purpose of my post last night was to give an indication of how I expect a covered call on a dividend paying stock to work for me.
F. My covered calls are written on stocks held in IRAs. The only stocks not in my IRAs are Drips and I don't write covered calls on them.
One thought that occurred to me--The covered call shows on the
statement as a debit until the option is cleared thru assignment or expiration, which might affect someone's reading the statement and knowing the true account value.
Selling a covered call on a dividend paying stock makes sense to me as it increases the amount of money I expect to make on that stock and increases the total value of my account.

 

[JPatrick]

<QUOTE: Selling a covered call on a dividend paying stock makes sense to me as it increases  the amount of money I expect to make on that stock and increases the total value of my account. :> QUOTE

I agree that covered call writing can be a good source of income during periods of strong premiums.  Of course the premiums are highest during rising markets when it can be argued that a simple buy and hold is superior.
All in all, not a bad place for a chunk of a portfolio if done right.

I still don't understand your thought that somehow call writing somehow goes especially well with div paying stocks  Nothing wrong with it, but I don't see a correlation between the two actions.  As I posted before, I have had stocks called early because the other party wanted to steal the div.  After all, if you hold a call that you plan to exercise in a few weeks and the div is now--why not exercise early?  On other occasions where I held a block of 500 shares or so with calls out on all of it, I've been exercised in 100 and 200 share blocks at a time.  One call owner wants the div so calls 200 shares while the other  guy doesn't so he calls on exercise date causing me to lose part of div and even worse two commissions.  I've also had this split exercise several times where the call was a Jan and the holder wanted to finish the tranaction in Dec for tax purposes. On a happier side, I have had a fair number of stocks that were in the money come expiration and they were not called for whatever reason.  Highest I've had was .74 out of the money and many more in the .01 to .25 range.  That makes good news on the Monday morning after expiration. 

 

[haha]

Covered call option writing has all the risk of holding the stock, yet it retains only a small segment of the reward. Within a narrow band of outcomes, because you pocket the premium you make out OK. Perhaps if dividends were much higher than risk free interest rates there might be some sense to this tradeoff, given relatively high implied volatility.

This strategy is only popular because most people doing it don't understand it. It sounds conservative, so it can be sold. But what if someone tried to convince you to embark on a program of naked put writing? Sounds risky, doesn't it?

Yet the key exposures are identical in covered call writing and naked put selling. In either case, you have an unbounded exposure to the downside in the underlying stock, offset to some degree by the amount you receive in premium.

Ha

 

[MooreBonds]

On a happier side, I have had a fair number of stocks that were in the money come expiration and they were not called for whatever reason. Highest I've had was .74 out of the money and many more in the .01 to .25 range. That makes good news on the Monday morning after expiration.

Many brokers now have auto-exercise provisions for clients. For instance, Ameritrade has a policy of auto-exercising options if they're $.25 or more in-the-money.

 

[Mr._johngalt]

Many brokers now have auto-exercise provisions for clients. For instance, Ameritrade has a policy of auto-exercising options if they're $.25 or more in-the-money.

My high school health teacher always told us that "auto exercising"
would cause hairy palms and failing eyesight. Hey, maybe it's not my monitor after all

Elvis has left the building..................

JG

 

[wabmester]

In either case, you have an unbounded exposure to the downside in the underlying stock

This is not true -- the downside is bounded.   The only time your downside risk is unbounded is when you sell a stock short.

Edit: oh, you probably meant unhedged downside risk in the underlying stock. That is true.

 

[ERD50]

pagar wrote.... earnings release dates may be a good day to purchase, or not.

pagar - I think you have a reasonable strategy for covered calls (though different from what I usually do). I always try to keep in mind - what does the call buyer expect? When you sell a call before an earnings announcement, the call buyer is probably betting on a positive report, and they can quickly sell the call at a profit. So just make sure that makes sense to your plan. Typically, a high dividend paying stock will tend to be less volatile, so therefore the calls will not sell at a high premium. But, if the call premium, plus the dividend, plus a stable stock look attractive to you - go for it!

Good luck - ERD50

 

[eridanus]

Wade Cook popularized covered calls as the path to riches beyond belief. Google on how he's doing now: "Wade Cook Financial Corporation (WCFC) has filed for Chapter 11 Bankruptcy and is no longer providing seminars for new or old customers."

http://www.thestreet.com/stocks/truthserum/1043588.html

I'd only consider writing naked puts (= covered calls) on an index, knowing that it will only tank when the entire market tanks, a la 9/11 or a 10/87. Scratch that - I wouldn't even do that.

There was a study of simple option strategies in the Journal of Financial and Strategic Decisions, Spring 2000, "Historical Return Distributions For Calls, Puts, and Covered Calls" by Gary Benesh and William Compton. Google on the title; I have a PDF copy if it can't be found. The conclusions aren't pretty.

A quote: "The year-by-year results reported in Table 10 indicate that CCs generally underperformed the underlying stocks in every year but 1987 where both strategies produced similar returns." Note that this was only for 1986-89. Maybe, just maybe, this time period is different.

Edit: Had year of crash wrong.

 

[haha]

This is not true -- the downside is bounded.   The only time your downside risk is unbounded is when you sell a stock short.

Edit: oh, you probably meant unhedged downside risk in the underlying stock.  That is true.

You are correct in your edit as to what I was trying to say. Also, by downside I didn't mean "loss", which is I believe what you may be referring to in your mention of a stock short sale. I mean literally down, as in the price of the underlying goes south. In my terminology, a stock short sale is exposed to unlimited loss on the upside, a stock held long or any option strategy which shares this profile has unlimited loss exposure on the downside. I am not saying it is likely that one would ever lose all- but it can happen.

It can be very useful to draw profit/loss matrices on various option strategies. Often, some of the popular retail strategies are just commission intensive and marketing intensive ways to accomplish what could be done more simply and more cheaply. If indeed one ever wanted to do it at all.

Ha

 

[bongo2]

"So what would you recomend I do at my annual meeting later this month?"

xprinter, if you haven't had your annual meeting yet, then you need to find out (if you don't already know) if the 1% is in addition to commissions, or in lieu of commissions. Also, tell your broker to provide you with your personal rates of return for each of the years that you have been with the broker. Make sure they don't include any deposits as "returns" and that they take out the fees that you've paid. Then compare that to what a simple, low expense, strategy would have provided. You can compare it to Scott Burns' "Couch Potato" strategy (50% bond index / 50% stock index), or even just investing in a low expense balanced fund (like Wellington). If your broker isn't giving you better returns for the risk that you are taking (and the odds are very good that he's not), then ask why you should be paying those high fees.

 

[brewer12345]

Often, some of the popular retail strategies are just commission intensive and marketing intensive ways to accomplish what could be done more simply and more cheaply. If indeed one ever wanted to do it at all.

Ha

Its the same thing that motivates the sellerrs of equity indexed annuities, variable life insurance, variable annuities with lots of guarantees, etc.