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7 Steps To 40% Annual Returns

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  

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."

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  1. VERY informative re covered calls, especially  info at ATM calls TWO TO THREE MONTHS OUT,  Many newbies (myself included) tend to write ATM front calls which are not as appreciable after all costs of trading are considered.  GABBY

  2. Gabby
    I agree… "two to three months out" is a great tip. An Englishman one said " a good tip is like a feather in your cap – after acquiring many like this, you eventually have a BONNET".

  3. But what if the stock keeps going up after you sold the calls?  Let’s say you sold GE calls for $1 at strike $12, and GE takes off.  In 3 months, the stock is at $18.  If you sit tight, your stock gets called away at your strike price of $12.  With the $1 premium, you effectively sold the stock at $13.
    I can think of 2 ways if you really want to keep the stock: One way is to have a stop loss on the calls and buy them back at the (higher) stop loss point.
    The other way is to rollover the short calls to a higher strike and possibly to a expiry month further out.  But be aware that, if you take this approach AND if you still want to keep the stock, you may have to pay a higher price to buy the calls back.
    I’d be very interested in hearing any other approaches.

  4. I look upon the short call as insurance against a downward move of the underlying stock. Since I bought the stock with the assumption it would move up, and when it does, the short call becomes an expense to the long term objective. In order to mitigate this expense I wait for an opportunity to DD or DDD and roll up and out to a higher strike and then dump the short call on a pullback. Then start over again selling the calls ( or covering with insurance) hoping for a repeat. The caller is paying you for the insurance expense. In my experience, most of my rolled short calls eventually expire worthless as you are continually adjusting the strike upwards.

  5. Stock up/Cwan – When you sell a covered call, think of it as selling the stock.  So if you are in GE at $12 and sell the $12s for $1.20 then you sold GE for $13.20 and you are just waiting to collect.  If you get called away, so what?  There are 9,000 optionable stocks to trade, if GE goes up and gets away from you, look for someone in the sector who is lagging and switch your play to there.  Of course you can roll or whatever too but there’s no NEED to stay in the stock.  Keep in mind we’re talking about 10% quarterly returns – if you get called away 4 times in a row, you shouldn’t complain – you should celebrate. 

    Gel has a great strategy for the long-term play.  You can always, at worst, roll horizontal so your "worst case" if you MUST keep GE for 12 months for some reason is you buy for $12, sell for $13.20 and then GE goes to $20 and never comes back and you just roll to the Jan $13s and the April $13s and the Sept $13s, picking up maybe .10 in premium each time.  That still gets you back $12.30 off the $10.80 you laid out for a 14% gain in a year.  Never waste time worrying about the upside, the idea is to buffer your investment to ride out dips and you take advantage of premium whenever you can but covering 10% a quarter means you have a 40% edge over naked plays. 

    Of course the worst case is the stock dives to $9 and you sell the Jan $10s and then it shoots back up but that’s why you need to manage size as well.  If you sell $12s for $1.20 and then $10s for .75, you net is $10.15 if you get called away at $10 but if you sell $12s for $1.20 (net $10.80) and DD at $9 (net $9.90) and then sell the $10s for .75, you have 2x at $9.15 with a call away at $10 over 6 months = 9.2% in 6 months, still not too shabby.

    If you combine scaling with this strategy, you just get called away on the ones that get away, roll the ones you can roll and DD (when appropriate) the ones that lose ground but are salvagable.  It’s a great way to spread your risk wide and, of course, if you pair this strategy with some broad index puts to take the sting out of a massive drop, you can realy limit your downside.