Question: I have been using Covered Calls exclusively since last December. I subscribe to a advice letter and have attended seminars by Compound Stock Earnings based in Ft. Worth, Texas. My question for you is: how do you pick your strike price? CSE always recommends a near month call for the initial position and secondary calls, if the stock has not dropped in price from the initial position. I see that you chose several months out and would like to know your reasoning. I know that there must be several different techniques for this.
Answer: Below you will find commentary from the SysCW FAQ Web page which happens to address this question. If you check out the ‘Want Proof’ section on the CSE Web site you will notice that all of the ‘proof’ stems from 2005 and 2006. Well . . . what I’d love to see is how they did in 2002!
The key issue I have with short-term call options lies in the requirement to be ‘right’. Needless to say, if the market is up trending, being right is relatively easy and the short-term system seems to be all that is says it is. The problem is when the market turns down. The short-term system will just not work at all during a down market.
SysCW, on the other had will work in either. The key rational for selecting a given strike price is downside protection. Heck . . . the duration can be one month, so long as the premium represents 15% of the investment. Systematic Covered Writing has to guidelines . . . 15% in the hand when the position is established, and 15% back-to-cash gain if assigned (annualized).
Can one generate more if they can repeatable sell short-term calls? The answer is absolutely YES . . . the problem is the shorter the term, the more the trade needs to be repeated in order to actually achieve the claimed yearly gain.
To that end . . . I will continue to play it safe as I sleep better that way. Thanks for the question . . . the FAQ information follows:
In researching, there seem to be extreme opinions on the benefits
of writing CCs. Some views are that over time, one can generate anywhere between 2 and 5% consistently each month either on stocks you
hold in an existing portfolio or newly acquired. i.e. view it simply as a cash generating method - if stock values fall away don't worry
..."
To begin SysCW wholeheartedly disagrees with the above statement. There are several relatively 'new' Web sources that propose the "two to five percent" monthly returns. Here is what 'they' are not telling you. They are not telling you that you will not be generating even 1% monthly, during a market down trend. Here is why they are unknowingly misleading the reader . . . they have not traded during a major down trend. Go to their Web site and look when their site became active. One of them even has a portfolio that you can see if you are willing to pay a significant monthly fee, but check out when that portfolio began! . . . Now look at these facts as of June 1, 2006.
(This may seem like a waste of time, but understanding what the market can do is basic to understanding what you should do.)
2006 Market Change
|
|
2006 Change in Index Values |
|||
|
Major Index |
Jan 01, 2006 |
As of 6/01/06 |
Change |
Percentage |
|
Dow Jones Industrial |
10,717.50 |
11,260.28 |
542.78 |
5.06% |
|
Standard and Poors 500 |
1,248.29 |
1,285.71 |
37.42 |
3.00% |
|
NASDAQ Composite |
2,205.30 |
2,219.86 |
14.56 |
0.66% |
Note that so far in 2006 the market is up-trending . . .
2005 Market Change
|
|
2005 Change in Index Values |
|||
|
Major Index |
Jan 01, 2005 |
Current |
Change |
Percentage |
|
Dow Jones Industrial |
10,783.01 |
10,717.50 |
-65.51 |
-0.61% |
|
Standard and Poors 500 |
1,211.92 |
1,248.29 |
36.37 |
3.00% |
|
NASDAQ Composite |
2,175.44 |
2,205.30 |
29.86 |
1.37% |
Note that in 2005, the overall change was 'flat to slightly' up. The market is made up of stocks. Calls are written against these stocks.
2004 Market Change
|
2004 Change in Index Values |
||||
|
Major Index |
Jan 01, 2004 |
31-Dec-04 |
Change |
Percentage |
|
Dow Jones Industrial |
10,453.92 |
10,783.01 |
329.09 |
3.15% |
|
Standard and Poors 500 |
1,111.92 |
1,211.92 |
100.00 |
8.99% |
|
NASDAQ Composite |
2,003.37 |
2,175.44 |
172.07 |
8.59% |
The market posted a reasonable gain in 2004. Short term calls would work well in this environment.
2003 Market Change
|
2003 Change in Index Values |
||||
|
Major Index |
Jan 01, 2003 |
Current |
Change |
Percentage |
|
Dow Jones Industrial |
8,341.63 |
10,453.92 |
2112.29 |
25.32% |
|
Standard and Poors 500 |
879.82 |
1,111.92 |
232.10 |
26.38% |
|
NASDAQ Composite |
1,334.00 |
2,003.37 |
669.37 |
50.18% |
A great year. As long as you were bullish, almost any investment should have done well, including covered calls.
2002 Market Change
|
2002 Change in Index Values |
||||
|
Major Index |
Jan 01, 2002 |
December 31, 2002 |
Change |
Percentage |
|
Dow Jones Industrial |
10,021.50 |
8,341.63 |
-1679.87 |
-16.76% |
|
Standard and Poors 500 |
1,148.08 |
879.82 |
-268.26 |
-23.37% |
|
NASDAQ Composite |
1,950.40 |
1,334.00 |
-616.40 |
-31.60% |
Yuk! Short-term covered writers would have lost their preverbal shorts in this market. You buy a stock and sell a call with a premium of 2% to 5% and the stock goes down 15%. You are immediately in a losing position and 'they' suggest that you take the money off the table and try again.
Shorter term positions that only bring in a limited amount of cash, increase the risk of covered writing. That is not an opinion, it is a fact. We are not talking about what the stock may or may not do during the holding period. It may go up, it may stay the same or it may go down. We just don't know. If you invest in a position for $2000 and you only receive $80, by definition, you are taking a greater risk than if you buy exactly the same stock and bring in a minimum of $300. This is what the covered writer means by a 'greater risk'.
Short term advocates will go through a song and dance about how they can do more trades and generate more money. The covered writer says that may be true, but they are taking a greater risk, and their strategy will only work if the market is up-trending. For what it's worth, the covered writer has been actively trading covered calls since 2001.
Thanks again for the question. I hope the answer was satisfactory.