Many financial advisors and more than a dozen websites advocate
writing (selling) covered calls as a sound investment strategy.
Thousands of subscribers pay millions of dollars to get advice on profitable
covered calls to write.
I believe they are wasting their money. Writing covered calls only
limits the potential gain you might enjoy.
Let’s take an example. You buy 100 shares of XYZ for $80 and write
(sell) an at-the-money two-month call ($80 strike price) for $4.00. If
the stock stays flat, you will earn 5% on your money for the period
(plus collect a dividend if there is one). If you can do this six times a
year (write a two-month call six times), you will earn 30% annually
(less commissions); or so goes the promise.
(In the last chapter we showed that selling calls against a one-year
option rather than stock results in a hypothetical 300% gain if the
stock stays absolutely flat, or ten times the amount you could earn by
writing calls against the stock.)
In this covered call-writing example, 30% is the maximum amount
you can earn. No matter how high XYZ goes in price, you can never
earn more than 30%. The bottom line truth is that you will NEVER
earn that 30%. The reason is that no stock price ever stays the same.
If the stock goes up by $5 in the first 60 days, you will either lose
your stock (through exercise), or more likely, you will buy back the
call you wrote, paying $5, and losing $1 on the call (but making $5
on the increase in the price of the stock). So for the first 60 days, you
actually made a 5% net gain ($4 net gain on a $80 stock).
Presumably, you then sell another 60-day at-the-money call (now
at the $85 strike) and collect perhaps $4.25. Then the stock falls back
to $80. In this time period, you gain $4.25 from selling the call but
you lose $5 in stock value for a net loss of $.75.
Your gains on the calls you wrote now total $3.25 for a 120-day
period (you gained $4.00 in the first 60-day period and lost $.75 in
hoped would earn you 30% for the year).
At this rate (four months of activity), your annual return will be
$9.75, or 12.2% on the original $80 stock. Commissions on six sales
of calls over the year will considerably reduce this return — to 10%
or so. Not a bad return, but certainly not 30%. And it’s an awful lot of
work for a 10% return.
For a full explanation of an option strategy that is designed to outperform writing covered calls, check out Dr. Terry Allen’s Free Report on calendar spreads.
As its ticker symbol implies, Salesforce.com (CRM) provides cloud solutions for customer relationship management needs. CRM reported earnings in late August that blew away expectations on both the top and bottom lines. The report was met by the usual round of target price increases that reached as high as $340 (CRM closed at $260 on Friday).
The stock gapped higher after the report and extended as much as 5.5% higher the next day, eventually closing with a 2.5% gain. But the shares then sagged, joining the rest of the market in the early-September swoon. In fact, CRM fell more than 8% from its post-earnings high.
But the shares appeared to find a bottom last week, thanks to the support of the 50-day moving average. Since turning higher in May, the 50-day has supported pullbacks in July and August. CRM has been stepping higher since a low in early March, putting in a series of higher highs and lows in a rally that has covered nearly 30%. This trade is relying on this trendline support holding for the next six weeks, as the short 250 put of our credit spread is just below the 50-day.
Sell to Open CRM 29Oct 250 put (CRM211029P250) for a credit of $1.10 (selling a vertical)
This credit is $0.02 less than the mid-point of the option spread when CRM was trading at $260. Unless the stock rallies quickly from here, you should be able to get close to this amount. Your commission on this trade will be only $1.30 per spread. Each spread would then yield $108.70. This trade reduces your buying power by $500 and makes your net investment $391.30 ($500 – $108.70). If CRM closes above $250 on October 29, both options will expire worthless and your return on the spread would be 27% ($108.70 / $391.30).
Copart (CPRT) provides online auction and vehicle remarketing services in the U.S. and several other countries. On Wednesday, the company reported Q4 earnings that easily beat on the top and bottom lines. Used car prices are soaring and CPRT is positioned perfectly to leverage the market. Analysts seem to agree, as CPRT received several target price increases that ranged up to $165 (CPRT closed at $143 on Friday). Despite the positive news, the stock fell as much as 5% on Thursday before closing 2% lower. However, CPRT gained more than a percent on Friday amid a down market.
The stock has been in rally mode since late March, gaining more than 30%. The 50-day moving average has been instrumental in guiding the uptrend, containing pullbacks in May, June and August. The trendline appears to be doing its job again, as it supported this week’s post-earnings drop. This trade is relying on this support holding for the next five weeks as the short 140 put of our credit spread is just below the 50-day.
If you agree that CPRT will stay above the 50-day moving average (red line in chart), consider the following trade that relies on the stock remaining above 140 (blue line in chart) through expiration in five weeks.
Buy to Open CPRT 15Oct 135 put (CPRT211015P135)
Sell to Open CPRT 15Oct 140 put (CPRT211015P140) for a credit of $1.20 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when CPRT was trading at $143. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $118.70. This trade reduces your buying power by $500 and makes your net investment $381.30 ($500 – $118.70). If CPRT closes above $140 on October 15, both options will expire worthless and your return on the spread would be 31% ($118.70 / $381.30).
Software developer (QuickBooks, TurboTax) Intuit (INTU) reported earnings on Aug. 24 that handily beat estimates on all fronts. Earnings came in at $1.97 per share, topping the analyst forecast by 24%, while quarterly revenue of $2.56 billion beat the estimate by 10%. The company also raised its quarterly and annual revenue and earnings guidance above expectations. To top it off, INTU raised its dividend and approved a new $2 billion repurchase authorization.
The Street clearly loved the report, as the stock was hit with several large target price increases (one raised the price 27%). The average new target price after these raises was around the $640 mark, which is 13% above INTU’s closing price on Friday.
The stock price took the news and target increases in stride, though, with no change on Thursday after the report. On Friday, the stock resumed its huge rally with a 2.4% gain. INTU is up nearly 50% in 2021, with most of that gain coming in the past 3-1/2 months. The shares have been riding along their 20-day moving average, a trendline that has not allowed one daily close below it since mid-May. The 20-day is currently at 541 but should cross above the 550 level in less than two weeks at its current pace. This is also the site of the short put strike of our credit spread.
If you agree that INTU will continue its rally along the 20-day moving average, consider the following trade that relies on the stock remaining above 550 through expiration in seven weeks.
Buy to Open INTU 15Oct 540 put (INTU211015P540)
Sell to Open INTU 15Oct 550 put (INTU211015P550) for a credit of $2.80 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when INTU was trading at $566. Unless the stock rallies quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $278.70. This trade reduces your buying power by $1,000 and makes your net investment $721.30 ($1000 – $278.70). If INTU closes above $550 on October 15, both options will expire worthless and your return on the spread would be 39% ($278.70 / $721.30).
Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad
This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).
Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.
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Options are not suitable for all investors as the special risks inherent to options trading my expose investors to potentially rapid and substantial losses. Please read Characteristics and Risks of Standardized Options before investing in options
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