Welcome to the final segment of my series about options and how to use them properly. If you are visiting for the first time please reference the previous articles in this series:
- How To Use Bull Call Spreads
- How I Use Bear Call Spreads
- How To Use Bull Put Spreads
- How To Use Bear Put Spreads
- Buying Options Is A Fool’s Errand
- Selling Options – How To Start Your Own Casino
- How To Sell Options Successfully
- How To Sell Covered Calls
Last segment I walked you through how I sell covered calls. Today I’m going to show you how I find great candidates for the covered call strategy and how I execute the trade.
Finding Great Candidates
The desired result when selling a covered call is to have the stock called away from you. This means that I count on making a profit from the capital gain and the premium. There are two factors that make for a good covered call strategy:
Extreme Optimism when a business is fairly valued and Extreme Pessimism within a great business!
Let me explain…
At the end of 2010, Netflix was the buzz everywhere, people in my office were talking about it, advertisements on the web were rampant, the forums at Motley Fool were buzzing about the company’s promise, in short everyone and their mother was talking about Netflix. When I took a quick glance at the stock I saw that their P/E ratio was around 25. I don’t use the P/E ratio metric when considering purchasing a stock, instead I use the cash flow measurement. However, I wasn’t interested in purchasing this stock, I was interested in making a relatively quick and low risk profit. I consider a P/E ratio of 25 very expensive, however Netflix was considered a consumer tech stock and from past experience tech growth stocks are known to trade at ridiculously insane P/E ratios. If you need a point of reference just think about the 2000 tech bubble or the most recent bell weather Apple.
The next step I took was looking at a basic technical indicator, the simple moving average (SMA). I use the SMA of 120, there is nothing magical about this number you could probably use 115 or 125 and be just fine but I’m looking for the overall trend in the stock. Here is what I saw:
As you can see Netflix was trading above its 120 SMA. This is a bullish trend. Additionally Netflix was hitting 52 week highs, which is another bullish indicator. The setup was perfect!
When selling covered calls I typically try and sell calls that are 90 days out. I find that this is when time decay really starts to pick up. In this case I looked at the March and April calls. Let’s take a look at how Netflix performed over the next couple months.
As you can see the stock almost doubled within the time frame of my covered call. This drove me crazy to say the least! I spent around $5200 for the shares of Netflix and made a small 5-6% profit when I factored in capital gains and the premium but geez I could have doubled my money if I had held the stock outright! Sadly this is the risk you take when selling covered calls but I knew when entering the trade I didn’t want to own this stock long term. It didn’t pay a dividend and it was extremely overvalued in terms of value investing. I remember this trade so vividly because I have never been so upset while making money! However at the end of the day I had to remember that long term investing is a war of attrition. I have to constantly and consistently win small battles in order to be victorious. Going head to head with wall street giants is for fools or the insane!
The next covered call strategy is my personal favorite! Finding great businesses that have extreme pessimism based on a situation or scenario that will blow over.
In November Western Union announced earnings that were less than stellar and the market in my opinion overreacted giving the stock a 33% haircut overnight, take a look!
This was AWFUL for current investors and had I been invested in the stock I would have been forced to sell because of my NO EXCUSE 25% STOP LOSS rule. But as we know with investing, “One man’s pain is another man’s opportunity!” And this my friends was an opportunity for me!
At $12.40 WU traded at 7 times positive cash flow and paid an annual dividend of 4% The company continually buys back it’s own stock and had steady cash flow. In order to take advantage of the market’s over reaction I sold a covered call.
Here is how it turned out!
I was able to make 2.9% return on my money within 6 weeks which isn’t bad at all, if I conducted that type of trade every six weeks it would be an annualized gain of over 20%.
The covered call strategy if done correctly isn’t sexy. Chances are you would have made money if you held the stock outright however I would urge you not to beat yourself up. Remember we are in this for the long haul, I love sleeping well at night knowing my investments are low risk!
Does my covered call strategy have any similarities to your covered call strategy? How do you trade covered calls?
Here’s to our Wealth!