Systematic Covered Writing

 . . . more than just covered calls . . .

FREQUENTLY ASKED QUESTIONS

PLEASE:  If you have a question ... please ask it.   Expanding this page will benefit many readers.  If you will take the time to ask the question, the time will be allocated to provide an answer.  Use this link to ask questions about Systematic Covered Writing.  Question

March 2006 - The following questions were received by the covered writer on March 8, 2006. They are very good questions and it seemed reasonable to share the answers with everyone with an interest.  The person asking these questions has received the first five examples of SysCW. Some of the questions will be answered as the series of 35 examples continue. With this in mind . . . here is the message the covered writer received today.

"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 - if they are good quality stocks, they have a chance of coming back (wont go out of business). Still generate cash when the stocks are down, so reducing the cost base.

The other view is that you limit your upside if a stock takes off, and still have all the downside exposure (less any premium received).

Obviously you are positive on CCs. Where is the reality on this? I feel that this can be a great way for generating cash income over the long term. If I want to generate 10 - $15,000 a month from this technique, am I being realistic (assuming I have sufficient investment capital to use), or have I simply got rocks in my head?

All the views consistently say buying options to make money is VERY hard work, and that most option buyers lose - therefore the option writer has to consistently win in the long run (I guess the option writer can also buy options as insurance protection)."

 

Question - "The other view is that you limit your upside if a stock takes off, and still have all the downside exposure (less any premium received)."

 

Reply - This is a very common concern, or misunderstanding, which in many cases prevents investors from using covered calls in the first place. A specific example was created as part of the introduction to Systematic Covered Writing to address this issue. To view this example please click UPSIDE. I believe the information in that example addresses most of the concern expressed in the question.  A few additional thoughts . . .

 

If an investor knew which stock was going to "take off", then he or she would be foolish to write a call against it. FYI, the information in the booklet mentioned in the linked example was written in 1994 and it is still being used to 'scare' people in my opinion.

 

Risk -  I linked to some additional information about risk which you may find valuable. If you would like to explore additional thoughts please click MORE.

 

Question - "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 ..."

 

Reply - I will begin by stating that I wholeheartedly disagree with the above statement. There are several relatively new Web sources that taut 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 2% 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 March 8 ,2006.

 

(This may seem like a waist 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 3/08/06 Change  Percentage 
Dow Jones Industrial 10,717.50 11,005.74 288.24 2.69%
Standard and Poors 500 1,248.29 1,278.47 30.18 2.42%
NASDAQ Composite 2,205.30 2,267.46 62.16 2.82%

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 about 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 I mean 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. I say 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 the end of 2001.

 

Question -   . . . "If they are good quality stocks, they have a chance of coming back (wont go out of business). Still generate cash when the stocks are down, so reducing the cost base."

 

Reply - I agree completely with the bulk of this statement.  Using Systematic Covered Writing, we express this as 'like the stock' before you love the premiums. The very last phrase maybe referring to the practice of telling investors that the premium from selling the calls reduces the cost basis. This can be true, but I would venture to say that in over 95% of the time, this is an illusion and a fabrication to make the returns 'look' better than they really are.  This is a very important concept.  Please click COST BASIS to view a resent reply the covered writer sent to a subscriber.

 

Question -  "All the views consistently say buying options to make money is VERY hard work, and that most option buyers lose - therefore the option writer has to consistently win in the long run (I guess the option writer can also buy options as insurance protection)."

 

Reply - A few comments . . .digging ditches is HARD work, buying options and being successful is DIFFICULT work . . . which is confirmed by your statement "that most option buyers lose - therefore the option writer has to ... win in the long run."  You've discovered the secret.  Most option buyers do lose.  Statistically, options expire worthless about 80% of the time.  That means that 80% of the time, some buyer ends up on the short end of the stick.  This is exactly why we are sellers, not buyers.

 

Others may have different opinions, but the multitude of strategies in the Systematic Covered Writing process provide strategies . . . continuously . . . so that buying insurance is not needed or nor is it advised. The 'out' is always based on the fact that we are committed to being long-term investors.

 

Question -  "Obviously you are positive on CCs. Where is the reality on this? I feel that this can be a great way for generating cash income over the long term. If I want to generate 10 - $15,000 a month from this technique, am I being realistic (assuming I have sufficient investment capital to use), or have I simply got rocks in my head?

Reply - There is nothing incorrect with your statement.  My expertise comes from years of holding covered positions. This is not the same as being a market maker that sells and buys calls and LEAPS.  They are trying to make their money on the spread . . . not on the positions themselves.  Please realize that for every buyer there is a seller. Both parties believe they are right, otherwise they would just be blowing money.  Systematic Covered Writing provides a road map addressing the 'plan' you mentioned in your question.

 

Thanks again for asking some great questions!

 

The Covered Writer

 

SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised: 01/30/07