Systematic Covered Writing

 . . . more than just covered calls . . .

Question: I am fairly new to your system, but it makes a lot of sense to me. ... I have been using [another system] for about a year and have done well, but I am “stuck” in a few positions using [one of their techniques]. I don’t know if you are familiar with it – on a down-trending stock you sell a far out call and buy it back when you have made 4-5%. However, if the stock increases, you cannot BB the call at a profit. I would like to ask your opinion on one of these positions. I certainly understand if you can’t answer, as this is not your technique and would never have gotten in this mess, but I am curious if you have a way out. [They keep telling] me to keep waiting for a downtrend.

Here goes:

12/19 Bought RDC @ 35.31. I have made 3.90/share so far on CC.

3/20 STO Jan 08 25 @ 7.90, had a GTC order to BB @ 6.10. The stock went steadily up and is now at 40.16 and the option is 16.00 (-8.10 to BB)

Any ideas?

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My Response: I have stated for years that short-term covered call positions are great if they are assigned, but not so great if they are not.  The two philosophies, and what to do when 'stuff happens' are about as different as night and day.  In responding to this question, you will notice a conflict between the two approaches.  I would ask you to consider this thought process as you evaluate the response.  Which philosophy requires the writer to be correct in their decision (or position) in order for the strategy being suggested to 'work'.

We all know that when a strategy works, there is no 'issue', the key then, is in knowing what to do when a strategy does not work. Having said that, take a look at a price chart of RDC from October of 2006 through June 26, 2007. What the writer sees is a stock that was up-trending nicely in October, November and into mid December of 2006.

The calls that were sold were not provided, but obviously they were short-term given that the new (existing option) was sold on March 20, 2007.  Now it is obvious that this is an isolated example, but imagine where this writer would be if a normal SysCW position would have been established in December of 2006.  With the stock trading at $35.31, the writer would have either used a June option or a January 2008 LEAP at the $35 strike price.  Why?  Because 'nobody knows', and because this is true the process requires two guidelines to be met:

1. We want at least 15% of the amount invested back in our hands the day the first call is written.
2. We also want an position where if the stock is assigned, we are 'happy' with the annualized return.

Once again . . . a short-term position is great if it works . . . but in order for it to work, the stock must do something, or not do something, in a relatively short period of time.  In other words, you have to be 'right'. With the SysCW thought process, it is 'okay; if you are wrong, because the position has already provided the writer with at least 15% downside protection.

Okay . . . back to this situation.  On March 20, 2007, RDC traded between  $31.62 and 32.84. Here we come to another major difference in strategy approach.  'They' suggest selling a long-term ("far out") option, and then buy it back when a gain on the option of 4 to 5% has been realized. They even provide a rule for which strike price to select.  The difference in opinion lies in the fact that SysCW would never suggest selling a call that is below the current trading price of a depressed stock.  The only way that 'strategy' can work is if the stock stays where it is, or loses value. This requires the writer to be 'right', when everyone knows that if fact . . . nobody knows!

Notice that with the first call, they suggest short-term and making money because the stock is going to hold or appreciate.  Then, if wrong, their strategy suggests making money with calls that are losing value because the same stock is now losing value!  Seems to this writer like a lot is riding on the investor being correct and switching strategies midstream. Again . . . if you are right, it will work. The question becomes . . . what if you are wrong?

If the stock reverses, as is the case with this example . . . a writer is going to be stuck . . . real quick!  With a cost basis of $35.31, and the stock trading between $31 and $32 a share, there is no way SysCW would suggest selling an option with a strike price below the current trading price of $32.  This would mean the writer would sell the shortest term $35 option which would bring in enough premium to justify the transaction.

So . . . hind sight being just that . . . what can one do? Here, as best as can be told, is what the SysCW Position Tracker would look like for this position at this time:

One of the keys to Systematic Covered Writing is record keeping. This simple Excel file shows that the position has generated $1,180.00 so far.  The real problem is with the strike price.  Keep in mind, I do not know how this will pan out mathematically, but here would be the possibilities:

1.     Close the position, and let it be a lesson learned.  The lesson?  Always use a strike price above the current trading price when re-covering a position that has lost value.  Always!  Make it a rule.  Why?  Because nobody knows what is going to happen to the price of the underlying stock.  Play it safe!
2.     Do nothing, and hope that RDC loses value over the coming months. 
3.     Use the SysCW Combo Buy Back & Roll Out & Up strategy to increase the strike price and prevent assignment.
4.     Roll the current option Out & Up.

Again . . . these are just thoughts, now let's see how the math works.  Please note that this process (seeing how the math works) is fundamental to the philosophy of SysCW.  Take as many 'ifs' out of the process as possible. With this in mind, let's look at our plausible solutions to this dilemma.

CLOSE THE POSITION

This is simply a matter of buying back the '08 Jan $25 LEAP and selling the stock.  The position would be back to cash.  Here, as of June 27, 2007 is how this would pan out:

Keep in mind the quotes used are a snapshot in time . . . but . . . as of this moment, this position could be closed with a small profit. SysCW suggests that one should look at the forest, and not the individual trees!  The forest, in this case, is all of the data for this position, where as a 'tree' would be the fact that it would cost $1,638.25 to Buy Back the option that was sold for $790.00. The writer politely says . . .  so what?  You would also be selling the stock for more than the $25 strike price and you would be keeping the $390 that was previously generated.  Shoot . . . it's not like one is ever going to go broke making money!

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DO NOTHING

Think about this . . . there are only two things that can happen from today on with the assumption that the writer of the '08Jan $25 LEAP does nothing.  Either the stock is going to be assigned at $25 or it's not.  There are no other choices.  So, taking the second one first, if the stock is trading below $25 in January 2008, the option will expire and you will be holding your 100 shares of stock and the $1,180.00 in cash that has been generated to date.  According to SysCW standards, that is just fine!  Your investment of $3,838.00 would have generated over 33% in new cash during the first thirteen months.  I would hope that would be 'okay'.

Now . . . what if it is assigned?  Well . . . by doing the 'math' , we can see the following:

Once again . . . this is not 'bad'.  No, the position did not generate 3-5% per month as 'they' suggest you should strive for, but you also would not lose anything.  Investing is not perfect, and neither is covered writing. If the positions that don't work can still end with a gain, you should come out okay. It would appear to this writer, that doing nothing would 'work' also.

The key thought between choice 1 and 2 would be if you went back to cash now, could you not generate more between now and January than the difference between $125 and $60.75?   See how easy it is to decide?

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COMBO BUY BACK & ROLL OUT & UP

The focus of this strategy would be that for some reason, you do not want to 'lose' the 100 shares of RDC that you purchased on December 19, 2006.  SysCW suggests that your money does not care what it owns, but possibly an investor might want a given stock to be maintained.  Let's see how this would work out:

Remember, the prices are a snapshot in time. Notice that by using the SysCW Combo BB&RO&Up strategy that one could increase the strike price from $25 to $40, which is above the combined cost basis of the 200 share hypothetical position.  The problem is you would only have 19.35% of your investment back, and the funds are tied up until 2010.  If for some reason . . . you needed to 'keep' the RDC position, it's not like this would not work . . . it's just not a position worth writing home about.

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ROLL the OPTION

At this point, even if you went out to 2010, you could not roll the $25 strike price to a $30 strike price.  Yes, you can do it, but you can not do it and add cash to the portfolio.  I would say this possibility is not an option at this point in time.

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CONCLUSION: From the writer's perspective, even with the error of selling a call below the trading price of the stock, you could still have this position end with a gain. Based on the math, it would seem like the 'best' plan would be to close the position with the small gain now, and get the funds working again in a new position.  Short-term . . . if you feel lucky, of a SysCW longer term Initial position if you want to rely less on being 'right'.

Your comments and opinions are worth sharing . . . . rlcoveru@wavecable.com

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PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN RDC STOCK OR ANY OTHER EQUITY.  THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED! STRATEGIES INVOLVING TAX ISSUES SHOULD BE DISCUSSED WITH YOU TAX PROFESSIONAL.

The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.

These are the terms of use.  Why are they here?  Because the examples provided are real.  The transactions actually took place.  The dates are real, the positions are real.  Some transactions will have been executed on the day you receive the email.  What you are agreeing to, is the fact that in no way is it being suggested that you can, or should, enter a similar position.  Why?  Because that would be providing investment advice and the Covered Writer is not authorized to do that.  There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice.  Therefore, you are agreeing that the preceding example was provided for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2007. All rights reserved.
Revised: 06/28/07