Covered Call Strategy Preview
Ever since the straddle’s did not work out, I have been thinking about a covered call strategy, but I didn’t get a chance this weekend to model it out and see if it is a good idea or not.
In general, covered calls are a conservative strategy, where you sell an option for someone else to buy a stock you already own. Your goal is for the stock to slowly go up, thus, it is never profitable to execute the stock, you keep the option premium and you keep the appreciating stock.
In the recent market, you have no idea what the market will do 30 days from now, or even tomorrow. Volatility is at an all time high, and I want to take advantage of it.
My idea is to buy QQQQ, which is the nasdaq index etf trading around $30. Then sell a covered call at around $2 at the money. The goal would be to sell the option at a price that would get exercised, ending the month completely in cash again. If strategy outlined above worked out exactly as described, it would generate 6.7%/month. After accounting reality and trading costs, this strategy still looks like it could generate 5%/month. And what is 5%/month compounded? Close to 80%/year.
The first thing my wife will ask is, if you can make 80%/year, why isn’t everyone doing it. First, high volatility means high risk. I am interested in QQQQ because it is an index ETF I would not mind holding in my portfolio for its current value. QQQQ could drop 20% over the next month, and then that 5% return on the option doesn’t look so hot next to the 20% loss on the underlying stock. Second, volatility is at an all time high. People are making money of this oddity, but covered calls are typically used for low volatility stocks, so the people who typically use a covered call strategy to eek out small gains, have stepped aside since market conditions now make it risky to continue to sell calls. Third, this volatility level will not continue forever. Once the markets calm back down, the option premiums will drop, and the strategy will be less profitable.
As an example of how much the volatility changes things, let me outline roughly what I was doing with covered calls a few years ago and what the market looks like now. A few years ago, I had an index backed etf that was trading about $70/share. An option one month out was trading at less then $0.90 consistently, and to make over a dollar, an option had to be sold in the money or more then a month out. Now there is an index backed etf trading about $30/share, and an at the money option one month out is trading for about $2. To simplify, lets say the first period had options trading at $1 at the money, one month out. That works out to be $1/$70=1.4% return versus $2/$30=6.7% return. So you need less then half the investment to make twice the return. With a goal of income, this is the market to sell covered calls.
Obviously the premiums have increased in cost because of the increased risk associated with holding the underlying stocks. Does the reward justify the risk? That is the research I didn’t get to in my short weekend.
October 27th, 2008 at 7:36 pm
it is an understandable strategy. an even better strategy if you are sure of the stock does not rise alot. However as noted, stocks are moving alot at the moment.
The problem with the strategy though, is that it sucks out all of your good stocks. As the plan is to try and be rid of the optioin before being excersied, but this may not happen. Options traders generally dont do this option for that reason, as it leaves you with only the less performing stocks in you portfolio.
it is just a protective strategy, in which case it is far better to use a collar…..