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7 Steps to Consistently Making 30-40% Annual Returns

Option Sage Submits:

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!

Step 1:  Wait for a selloff

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 $14.68 offers an attractive entry point and with earnings coming up next month and the short July calls at strike $15 close to the money offer $1.33 of premium, just slightly greater than 3 months away, the return on risk may be calculated as follows:  $1.33 divided by $13.35 of risk (if the stock should stay flat).  That equates to a return of 9.9% in 3 months.  And, if the stock should rise to $15 within 3 months, which requires just a 2.2% increase in stock price, the Covered Call position would gain 12.4%.  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-qualified accounts, but retirement accounts can be perfect for this type of strategy.  Slow and steady wins the race!

Remember, patience is key!  Phil has regular lists of stocks that are "on sale" and even on our "closed" Buy List there were still 15 stocks Phil was willing to stick with.  Remember – your stock may not always go up but, using this strategy to make sure you make about 3% a month in premium sales insures that you will beat the stocks regular performance by 40% per year – doesn’t that seem like a sensible goal to enhance long-term performance?

 


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  1. terrapin22

    I’m not following your numbers in GE example.  you mention stock at $18.34 and then at $30. 

  2. Phil

    This was a re-post of an old article and you caught it in progress, GE has been replaced by WFR.

  3. terrapin22

    Okay, example changed.  WFR makes sense.  Thanks.

  4. Phil

    That’s a very important point, by the way – not all stocks work all the time.  That’s what the steps are for:  Find things on sale WITH good option prices that will get you to your goal.  It doesn’t matter how much you love a stock – if it’s not going to give you 3% a month in premium with satisfactory protection then it’s not a good choice. 

    As I often say, with 9,000 stocks to choose from there’s always something to buy, even in a bull market.  Even this week, in our cash position, we still found a few worth entering but, hopefully in a few weeks, we’ll find a lot more!

  5. gel1

    Phil
    I know you are invested in TBT, the inverse ultra ETF linked to bond yields. We know that rising interest rates will raise the yield rate on new issues, but an additional driver is the volume of new issues. Bond investors, many from outside our borders, are not so much concerned about the possibility of inflation, but are increasingly concerned about the bond supply needed to finance the deficits. The recent passage of the massive healthcare bill adds to this deficit concern. George Goncalves, head of fixed income strategy at Nomura, as well as others have made statements to this issue. I do not think we will have to wait much longer for an upward move in TBT.http://www.ft.com/cms/s/0/c51fbbce-3908-11df-8970-00144feabdco.html

  6. jburgess

    Option Sage:
    Although I’ve never posted to you before, I just wanted to take a moment to thank you not just for the fine article above, for all of the articles you have contributed, and for the training modules at Market Tamer. While not new to investing, by any means, I am relatively new to options trading. Your teaching methodology is organized, logical, and builds in such a way as to empower the individual without lending confusion. If I am recalling correctly, your background training is as an engineer…. your organization shows well in your teaching. So thanks again; I would recommend that everyone study your materials.

  7. jburgess

    Phil: great job with your protoge!!

  8. jburgess

    Phil:  protege. And I do mean it as a compliment.

  9. bobhu

    Phil,
     
    Great post.  Thanks.

  10. dflam

    Very informative !

  11. yodi

     
     
    How much of my capital shall I in trust to an individual stock broker?
     
    A Lesson I learn the hard way, which I would like to share with our group of Phils PSW.
    A possible quick answer would be for example TOS is insured for 1,000,000.00 per investor bare me to correction!
    On various occasions I have asked Phil to set up a more intricate plays on stocks, where I lost quite some money. I must say he did very well indeed.
    Here are some examples C bought for 35.00 now 4.00 BAC 42.00 now 17.90 HOV 12.00 now nearly 5.00 and DRYS 55.00 now 4.00
    Phil and as well you will ask, how can the man be that stupid to drop so low.
    Simple I in trusted my account to a stock broker North American Trading. Before the market crash the SEC found out that the above company was using customers funds for there own pocket. 27th May 2007 they froze all accounts. You could not buy or sell anything. I was just one of the lucky once, I only traded stocks with them no options. Some of my friends had about 900,000.00 worth of stock and options. They actually landed up owing money to the liquidator!!!
    Yes the Government insurance fund insured my stocks but not the value of the stocks.
    My portfolio was released May 2009. Stock values of some as shown above.
    I do not have to explain what happened to my friend’s options which all wildly expired!!
    By the way the operators of the brokerage firm are still free, where there is nothing the Diablo has lost its case and the Lawyers interest.  
     

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