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Three Styles of Buy-Writes in an IRA

A whipsawing market can disturb your sleep to the point where you feel like you spent the night sailing around the Cape of Good Hope in a hurricane rather than dreaming about how you will spend your retirement. I batten down the hatches by writing covered calls in my IRA virtual portfolio. Covered calls enhance returns in a range-bound market and make the IRA ship sail a little smoother in choppy wakes caused by the latest CNBC “USS Dome and Gloom” and “USS BuyBuyBuy” sail at your stern. The Education section at Phil’s Stock World (PSW) gives three great strategies on how to buy-write your way to a more peaceful retirement. I suggest you read the details of each of these strategies as you get the chance, but I will provide a brief summary and what I see as the strengths of each style of writing covered calls.

 
Discount Buy-Write
 
This is the backbone strategy at PSW to build a core virtual portfolio. The strategy is to buy a great stock coming off a market bottom and sell a call and put at a strike price that allows for a 20 percent or better discount on the purchase of the stock. Here is a great example from PSW sent to members on July 7.
 
XOM is a good inflation hedge and so beaten down (back to Sept 2008 spike lows, when oil was $40) that I have to include it.  They have a 3.1% dividend of $1.76 with the stock at $57.46 and we can sell the 2012 $55 calls for $9.20 and the 2012 $52.50 puts for $7.35 for a net $40.91/46.71.  That brings the dividend up to 4.3% and you make another 34% if called away at $55 with your worst case being owning 2x XOM at an 18.7% discount to today’s price.
 
The obvious advantage of this strategy is that you can make a decent income even if your stock drops and you get a 15 to 20 percent downside hedge. Even in a huge market drop, that will pay off leaving you greater capital to work with as you build your virtual portfolio back up. Second, these are long-term writes, often 6 to 18 months into the future. If you don’t have time to monitor your virtual portfolio every day or week, this strategy allows peace of mind while vacationing or just living your life. Third, if you are a PSW subscriber, Phil posts these trade ideas regularly on the best stocks and helps with the timing. Then it is a no brainer.
 
The Discount Buy-Write does limit profit in an IRA account. As I wrote a couple weeks ago, margin requirement for IRAs force you to cash secure the naked put, and these trades can suck up nearly three times as much margin in your IRA as in a margin account. That may limit your profit to about 8 to 10 percent a year, but with 15 to 20 percent downside protection, which I would rather do than trust my retirement to mutual funds. This is supposed to be safe money.
 
Virtual Portfolio Writing/ Dividend Capture
 
A variation of a long-term covered call strategy is to write long-term calls without selling the put. This gets away from the problem of naked put margin requirements. It is also a flexible strategy and Phil gives some good ideas at PSW in the article above. One way to do this is sell your covered call the month after you are due a dividend. Then there is no risk of getting called out ahead of the dividend and in a sense, you will get a double dividend four times a year. You can adjust your strike price to your market outlook. If the market looks terrible you could sell a call slightly in-the-money for more downside protection, sell at-the-money calls in a range bound market, and if a bull market is under way, why not sell an out-of-the money call and capture some capital gains as well? 
I think this is an excellent core virtual portfolio strategy. You can probably make a little more money, say 10 to 15 percent a year, with this strategy than the discount buy-write, but you will not have as much of a downside hedge in most cases. It doesn’t take a ton of time to do this if you are selling calls on a quarterly or yearly basis. Just pick a solid dividend payer, hopefully with a little bit of volatility for higher option premiums, and let your IRA sail steadily ahead.
 
Monthly Premium Capture
 
The monthly premium capture strategy focuses on selling calls every month on your stocks. Here is my case for why I’m using this as my primary strategy. First, I like the idea of making 30-40% a year in my IRA! Can this be done? Well, that is my one-year challenge in the IRA Plot. Second, I can be very flexible each month and pick stocks that have the short-term technical objectives I like, and I’m not committed to a stock for more than 3 to 6 weeks. I can choose from a number of stocks I like and only invest in the ones that have the combination of safety and higher premiums for that month. I generally get called out on almost all my stocks each month because I write in-the-money calls to increase my downside protection. My goal is to write calls on several stocks that will average out to a 3% gain per month with a 7 to 10 percent downside protection. It is a little hard to do when the VIX drops very low, but that is usually during a bull market and I will write some out-of-the money calls to raise my profit potential. 
 
I love this strategy, but there are two important downsides to take into account. First, you need the time to do this and it does take some research and technique. You can’t just pick any high premium stock option and write away. High premiums mean high risk such as an earning report is due or a merger is in the wings. I once wrote a call on a biotech company that was written so deep in-the-money that I had 60 percent downside protection and a 5% profit if called out. They had a bad trial on a drug and I actually lost money on the stock! Making money on monthly covered calls takes some training and self-discipline. I have a set of parameters that I have learned to follow no matter how much I like the juicy premium on a call option. I make myself follow these rules and I don’t get greedy. http://www.philstockworld.com/2010/08/20/ccj-trade-some-checkpoints-for-monthly-covered-calls/
The second potential issue is this strategy lacks the downside hedge of the discount and dividend writes. If the market drops 20% during a month, that 7% downside hedge doesn’t let you sleep at night like the discount write. But over the long-term, I think monthly covered calls can recover very quickly even in a terrible market. I started writing covered calls in September 2008, and I got hammered my first two months, losing about 30 percent of my virtual portfolio (which may sound lucky to a lot of people who watched their 401k get cut in half.) But I recovered all my capital by February 2009 and wrote monthly covered calls through the worst of it all. Remember that when the market plummets, option premium soars accordingly. I made a lot of money rolling down my calls to a lower strike and by being patient and writing a call the next month. Here is an example on PBR during that time period:
 
On October 31, 2008, I bought 200 shares of PBR at $26.49 and sold the Nov $22.50 calls for $5.32, leaving me with a cost basis of $21.17. If called out that November I would have made $133 per 100 shares for a profit of about 6.28%. PBR had just bounced from about $18 per share to $26 per share and I felt (stupidly) secure that it would hold $21.17 in a month. By November options expiration, PBR closed at $16.20 after bottoming out at $15 the previous day! It looks like I was the captain of the Titanic, doesn’t it? But the following Monday I sold the December $22.50 strike again for $1.30 and brought my cost basis down to $19.87. On December 5, the option value had dropped to 25 cents, so I bought it back at the bottom and sold it later in the day for 45 cents and dropped the cost to $19.67. On December 17, PBR had recovered and I closed the trade for a 10 percent profit on a stock that dropped from $26.49 to $22.50, a 15 percent drop! That was my best trade during the time period, but it wasn’t the only trade where I made money during a terrible market. Volatility can be your friend when selling monthly calls.
The bottom line is everyone needs to pick the right write strategy for themselves. I love doing monthlies not only for the profit because I like being more involved with my virtual portfolio than long term buy-writes of the discount and dividend strategy. I don’t have time to day trade, but I can still make much better than market returns and not be glued to the computer. For many people, a combination might work best. You could put half or more of your virtual portfolio into long-term discount writes for security and then write monthlies when you feel good about the market and make some extra profit. I wouldn’t recommend wading into monthly option selling lightly, but I hope I have taken some of the fear out of short-term writes. I believe writing monthly calls is a conservative strategy and for someone willing to put in the time, well worth the extra risk.
 

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  1.  Postscript  -  Phil made these comments on Fridays blog that I think are very relevant.  There are definitely always trade offs.  Not every stock is a good one for a monthly buy-write, and it is probably not a good strategy for everyone, for your whole IRA, but he gives two good examples of stocks for this monthly strategy below that I put in bold:

    Nothing is "free," there are always trade-offs between risk and reward.  Selling the 2012 $17.50s for $1.45 protects you to $14.64 (9%) and leaves you $2.86 or upside (19.5%) and is a reasonable trade-off if you are bullish.  Compare that to selling your 2% a month and having just 3% downside protection on any individual dip and having your upside capped at 2% as well on any given month. 
    This is why the buy/write is so powerful, because we can pair the protection of the 2012 $15s, with the willingness to buy another round at net $11.20 (30% off) through the sale of the 2012 $12.50 puts for $1.30.  That puts you in the stock for net $12.19/13.60, which is 15.5% downside protection FOR FREE and an upside of $2.81 (23%) plus the dividend.
    The question is not just, CAN you squeeze a little bit more out of PFE over 17 months but SHOULD you?  Some positions are worth working, like SPWRA or VLO, which swing violently up and down but which we have long-term faith in, so we can take advantages of run-ups to sell and sell-offs to buy.  Don’t confuse your INVESTMENTS with gambling. 
    If you keep the base of your portfolio in long-term, well-hedge positions, you won’t be subject to short-term market shocks and you can use your excess cash to take advantage of short-term TRADES that can make you 1% in a day or two while you DON’T have to worry about a dozen long-term INVESTMENTS that are safe and sound.
     


  2. Revtodd64: Very nice work. There is an excellent article on writing covered calls at http://www.poweropt.com/tipsheet4a.asp


  3. Rev – outstanding! Thank you so much. Now moving to mixed portfolio…..*cue up the music*
    (how come they never discuss most of these strategies in the standard books, even the one on this site!)


  4. Rev – Thank you so much for starting the IRA Plot.


  5. Rev—--great work--Tx


  6.     Rev,
    Nice article, I think this will work well for me.
    Please include me in your mailings, or however this gets set up :
    ekor77@hotmail.com
    Thank you


  7. I am new so forgive if stupid questions but on this example I do not understand some things:
    "XOM is a good inflation hedge and so beaten down (back to Sept 2008 spike lows, when oil was $40) that I have to include it.  They have a 3.1% dividend of $1.76 with the stock at $57.46 and we can sell the 2012 $55 calls for $9.20 and the 2012 $52.50 puts for $7.35 for a net $40.91/46.71.  That brings the dividend up to 4.3% and you make another 34% if called away at $55 with your worst case being owning 2x XOM at an 18.7% discount to today’s price."
    First, I am not sure why if you think the stock is a riser, you do not sell calls that are out of the money a little?
    Second, the worst case seems to be worse than you list.  What if the stock is at $40 for example at expiration time.
    Are you not out quite a bit having to buy the stock for $52.50 and the stock is down a lot?


  8.  XOM trade – The price of XOM at the time of this trade was $57.46.  The $40 price was the 2008 low.  That should clear up some of the confusion.  So selling the calls at $55 and the puts at $52.50 provides a hedge.  Hope that helps.
    XOM is a good stock to hold as an inflation hedge, because if the dollar goes down, oil should rise accordingly.  XOM rarely gets below $52.50, though clearly it does on occasion, but generally people consider XOM to be worth more than $52.50 even if the price drops, so owning it at that price is a good wager.  Actually you would own the stock for $40.91 after the premium income.  That is at the three year low, so it is a good hedge.