Just a couple of decades ago it would have been almost unfathomable for the retail investor to consider generating consistent returns above 20% per year. Indeed, those who competed in arguably the most competitive financial market place, the stock market, were considered gurus when they beat the S&P 500 year in and year out.
Others, such as Jerome Kohlberg, Henry Kravis and George Roberts made a name for themselves in private equity as did Peter Peterson and Stephen Schwarzman with the Blackstone Group. Gains in the stock market for Joe Public were subjected to a limiting factor – the inability to leverage substantially. Joe Public was also limited in participating in private equity investments; they were the domain of the rich – the insiders. These days, private equity still remains the domain of the rich, but leveraging is possible through the purchase of equity derivatives. And the sale of those same equity derivatives can be highly profitable too.
Whereas it would have been unthinkable years ago to consider making big profits year in and year out on a stock that doesn’t move much – because the only source of income, dividends, tended to be in the low single digits in percentage terms - these days options afford us the opportunity to sit tight and profit while holding stock positions. This can easily be achieved through the sale of short call options against stock holdings, otherwise known as the Covered Call strategy. While the Covered Call strategy may appear straightforward when first encountered, many applications may be employed. In this article, we will consider the application that Stock and Option Trades labels: 7 Steps to 40% per year!
Ok, so you want to skip this step and move on to Step 2. Wait!
One of the great quotes in investing comes from Jesse Livermore and pertains to this concept of patience. In Reminiscences of a Stock Operator, it is stated:
"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine--that is, they made no real money out of it. Men who can both be right and sit tight are uncommon."
Step 2: Check the Fundies
Because the Covered Call strategy comprises stock ownership, we should know that it’s close to a level that value investors will jump in, even if the stock drops lower in the short-term. Some simple metrics to look out for include:
Zero debt – in higher interest rate environments, debt-laden companies obviously suffer much more so than those with no debt.
Lots of cash – If you want to see an example of a company with lots of cash relative to its market capitalization, just check out OptionsXpress. With so much cash on hand, there is an automatic lower limit on how low the stock can go.
PEG: 0.65 – 1.0 A low PEG – anything less than 1.0 – indicates a company’s multiple is low relative to its earnings growth.
Return on Equity: 15%: A return on equity of 15% or more indicates the company is compounding value at a very attractive pace. Even if a stock isn’t matching the return on equity figure in the short-term, the likelihood is it will play catch up in the future.
A Story – Companies with a story are always attractive to Wall Street analysts. Whether it’s the iPod, global search, oil, consumer staples etc. companies in different sectors will come into vogue at different times and your job is to know what’s in vogue now! You can be stubborn and stick with a sector that isn’t moving much, but why remain so inflexible when another sector may be flying to the moon.
Step 3: Check the Technicals
Has the stock been beaten down? If so, it’s time to pay special attention to the turn. Wait for the bottom to form and the stock to take off. Chances are if Step 2 was executed properly, the stock that is fundamentally strong will blast off like a rocket ship when sentiment changes in the market. Make sure to be alert to the shift. You’ll know when it happens because suddenly everybody will be racing to buy as much as they can and greed will kick in!
Step 4: Note Earnings
As mentioned, many Covered Call strategies exist, but the one discussed in this article pertains especially to taking advantage of earnings. You can easily spot when earnings takes place by navigating to the investor relations department link on the website of the company under investigation or indeed by simply navigating to www.earnings.com
Step 5: Track Implied Volatility
By keeping a close eye on implied volatility, you will always know when options are expensive or cheap on a relative basis. In short, when implied volatility is high - as is usually the case right before earnings – options are very expensive. And when implied volatility is low – as is usually the case 1-6 weeks after earnings, options tend to be ‘cheap’ on a relative basis. Once the implied volatility starts to pick up, it’s time to start thinking about selling some expensive call options against the stock position you already own.
From steps 2 & 3, you should have ended up with a solid stock after it started to trend bullish. Obviously at the start of a bull run there is little reason to cap gains with short calls. But if a bull run has occurred and implied volatility is high because earnings is approaching, why risk all those gains? In fact, why not sell some expensive call options to lock in some of the gains?! And that’s where Step 6 comes in…
Step 6: Sell 2-3 month short call options at-the-money
Options at-the-money tend to have greatest premium compared to options in-the-money or out-of-the-money. Moreover, options with 2-3 months of time value can offer a nice compromise between choosing shorter term and longer term options. Shorter term options tend not have nearly as much premium obviously as longer term options but longer term options require that the Covered Call trader stick with a position for a long time. And while patience is key to successful long-term gains, it’s also important that you are not so bored with your positions that you lose interest in the game altogether!
Consider an example: WFR at $15.87 offers an attractive entry point and with earnings coming up next month and the short January $16 calls at $1.90 offer $1.90 of premium for January, just slightly greater than 3 months away, the return on risk may be calculated as follows: $1.90 divided by $13.97 of risk (if the stock should stay flat). That equates to a return of 13.6% in 3 months. The stock simply has to hold $16 over the next three months to provide a better than 40% annualized return! That is the outcome of purchasing the stock and entering the short call simultaneously. Obviously, by using some technical analysis to assist in timing the stock entry on the bullish turn and entering the short calls closer to earnings, the result could be improved.
Step 7: Wash, Rinse and Repeat
Now all that is necessary to produce gains of 40%+ per annum is to repeat each and every quarter! What would 40% per annum mean? On $25,000 of starting capital, 40% per annum for 5 years turns into $134,000+. Is that good? Perhaps, but it’s the next 5 years when the money really starts to mushroom. After another 5 years it turns into over $700,000! Obviously, taxes impact gains in non-qualifed accounts, but retirement accounts can be perfect for this type of strategy. Slow and steady wins the race!
Even if WFR drops 40% this year, selling the covered calls (as long as you collect $1.90 per quarter) will keep you even. Of course, a quartely drop of more than 10% is the biggest danger and, in this market, anything is possible but it’s a great, basic strategy to enhance your returns on stocks.
Don’t think of this as a one-time strategy, think of this as a long-term virtual portfolio builder. Much like Phi’s favorite investing film, "The Man Who Planted Trees" and Phil’s favorite quote from Charles Dow:
"The man who begins to speculate in stocks with the intention of making a fortune usually goes broke, whereas the man who trades with a view of getting good interest on his money sometimes gets rich."