A covered call strategy is a way of effectively 'renting
out' your shares for a steady income of around 5% per
month, in a similar way to renting out your investment
property.
Warren Buffet does it, as do a lot of the large
buy-and-hold investors, because it makes sense to generate
income on stock holdings while you wait for them to rise in
value, or to produce dividends.
It may not be right for everyone, of course, but if you're
interested in generating 3% - 5% every month from covered
calls, then you owe it to yourself to get as well informed
about the strategies as you can.
Now, in searching the web for more information on covered
calls, you may well stumble across an article on Motley
Fool called "Stay Away From Covered Calls".
The author, Dan Caplinger, makes the fundamental error of
seeing covered calls as a 'gimmick' that doesn't really
make much sense. His case is built on sand, and there are a
few large holes in his arguments.
This Motley Fool article has been brought to our attention
on a number of occasions now, and it's time to correct the
errors Mr Caplinger has made.
1. In his RS example, Caplinger says that the stock was
stuck around $20 for most of 2004 and 2005 (there's a link
to the 5-year chart below).
Assume the stock was 'stuck' for 20 months, and assume 5% a
month in premium income for selling the covered calls. That
means you'd be making $100 a month per option sold for
twenty months, for a stock holding of $2,000 per option.
So, after 20 months, your stock is effectively free,
because you've got back 20 x $100 in premium income.
2. All the time you're generating that income, you know the
stock is going to break out of the range at some point -
but up or down, and when, no one knows! It's fine now
saying it broke up, but it could have gone the other way
or, indeed, done nothing at all.
3. Once it does break up, and you get your stock called
away at a profit, there's nothing at all to stop you
getting right back in again! In the same hour! Assuming the
premium still looks good, and the charts look OK, this is
what a lot of covered call traders do.
You'll also notice from the chart that it wasn't quite the
smooth run from $25 to $60 that Caplinger implies. The
first break went to around $50, but then fell back to $30
before climbing again. There's plenty of opportunity in
there to make significant sums from covered calls in this
period, too!
Caplinger is basically arguing for a buy-and-hold strategy,
or what is sometimes called a buy-and-pray strategy, which
means you can only make money when the stock goes up. (With
dividends, maybe you make a bit if it holds steady, too).
With covered calls, you profit when the stock goes up, down
or sideways! You have far more bases covered. Sure, you
might miss a big move occasionally, but so what? As an
investor, you are never wrong to take a profit, no matter
what happens subsequently.
At Maverick Investor, we believe that...
(steady monthly income) + (no losing trades)
beats
(occasional big upward moves) - (money tied up in stocks
going nowhere) - (some losing trades)
Every Time!
I can't comment on the tax, but there are entirely legal
and above board techniques to trade covered calls without
paying any tax at all.
As for commissions, I'm amazed he even mentioned them!
They're so small now with online trading that that is
almost irrelevant. OptionsXpress, as an example, quote a
minimum of $29.90 for covered calls. Think or Swim are even
lower, starting at $2.95 per option contract, and a $9.95
flat fee for stock trades up to 5,000 shares.
All in all, this is not the most impressively
thought-through article I've ever read, and quite a
disappointing drop in the usually high standards at Motley
Fool.
----------------------------------------------------
You can find the Motley Fool article at
http://tinyurl.com/38hpoz
The 5-year RS chart is at http://tinyurl.com/34m44q
To find out more about making 5% a month from covered
calls, visit http://maverick-investor.com and click on the
Covered Calls section.
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