The Short Road to Long-Term Stock Gains

New subscribers to my publications often express their surprise that I use "covered call" options in a stock-investing service.

Generally, they expect to see that strategy in a more-advanced, or more-active trading service.

But the truth is, this easy-to-understand strategy works best as a tool for longer-term investors — even and especially those who don’t spend a lot of time on trading!

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Last week we looked at why options traders are good for the broader stock market. In other words, if you are enjoying a liquid, actively traded stock market, then you can thank an options trader.

Today, if you’re looking at harnessing the power of options to reduce your cost basis on stocks you love, I’ll show you how to do exactly that.

My Top Options Strategy

for Stock Investors

I use covered call options because this strategy generates cash, is very simple to understand and can be easily mastered with some professional guidance.

Unfortunately, there are a lot of misconceptions and misinformation about this conservative options strategy; some can even lead to heartbreaking losses — ones that frankly should never have to happen.

While there is some risk involved in the call-writing strategy, it may be one of most-powerful investing strategies you can ever learn.

Best of all, it’s something you can do in your IRA or other investing accounts!

What is a Covered Call?

A covered call (also called a covered-write, or buy-write) is a strategy where the investor buys stock and then sells a call option against it. By selling the call, you are giving somebody else the right to buy your stock at a fixed price.

The reason this strategy is called "covered" is because you are not at risk if the stock moves higher.

This is different from the trader who sells calls "uncovered" or "naked," as that position can continually lose money — theoretically an unlimited amount — as the stock moves higher. Naked call writing is one of the most-dangerous option strategies.

Covered writing removes this risk because you can always deliver the shares, no matter how high the stock is trading, because you already own them. The short call is "covered" by the long stock.

Here’s How it Works …

For example, you may buy 100 shares of Anadarko Petroleum (APC) at $82 and sell a one-month $85-strike call currently trading for $1.30.

What you just did here is this …

  • You bought 100 shares of APC at $82.
  • You "sold to open" (or "wrote," or "sold short to open") one call option contract at the $85 strike (or exercise) price … against your long 100 shares.
  • You collected $1.30 per share with the short calls, or $130 per option contract (contracts generally represent 100 shares of the underlying stock).
  • In this case, if it’s March, you would look to sell the April calls; in April, you can look toward selling May calls; and so on.

Now, for the next month, you might have to sell your shares at a price of $85. This is regardless of where the stock is trading.

That is, if a person who owns the call you are short chooses to exercise his or her right to buy shares at the $85 strike, it’s your obligation to provide shares at $85 (in this case, a $3-per-share gain from your buy price of $82).

In exchange for this right, the person buying the call paid you $130.

Theoretically, if the stock soars to $120 at options expiration, you will have to sell your shares for $85. (Now that would be a $38-per-share gain from your buy price!)

So on the surface; it doesn’t seem to be a bad deal. It’s like placing a sell limit order at $85.

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But instead of getting $85, you could net $86.30 a share ($85 for the stock + $1.30 for the call premium).

However, there is significant risk to the downside.

With our APC trade in this example, we paid $82 for the stock and received $1.30 for the option. The stock could fall $1.30 to $80.70 a share and we’d still be OK — that’s our breakeven point.

In other words, if we decided to exit the position at $80.70, we would wind up with neither a gain nor a loss. That’s because we collected $1.30 at the outset of the trade and lost $1.30 on the stock at that level.

That’s another small benefit of covered calls; they provide a small downside hedge. In other words, they reduce the cost basis of our long stock position.

But if the stock continues down from there, we get more and more into a losing situation.

In fact, the most we could lose, theoretically, is the $82 we paid for the stock, less the $1.30 we got for each option — a total of $80.70.

We are at risk only below the breakeven point.

The Critical Mistake Many Investment Professionals and Academic Journals Make with Call Options!

Many investment professionals and even academic journals will tell you that the risk of a covered-call position is that you may lose the stock.

That’s … an interesting way of looking at it.

Look, even if the shares are "called" away from you by the short call, you can always buy them back on the open market. In some cases, at a more-favorable price!

Risk, for most people, does not equal missing a reward. It is a loss of principal.

So if you get nothing else from this article, please understand that the risk of a covered call is that the stock goes down, not up.

If a professional tells you the risk of a covered call is losing the stock through assignment of the short call, ask him why it’s called a covered position?

He will likely tell you, "That’s because you’re not at risk if the stock moves higher — you will always be able to deliver the shares."

Think about it … on one hand the broker tells you the risk is that the stock moves higher. And on the other he tells you you’re not at risk if it moves higher.

Which is correct?

Are you still not convinced that’s the risk? Well, think about this.

Say you were thinking of buying a stock trading at $100 and asked your broker what the risk of the investment is. He claims, "Well, the risk is that you buy it for $100 and then sell it later at $120, only to watch it trade higher at a later date."

If that were really the "risk," the optimal strategy would be to bet the farm and buy all the stock you can.

Buying at $100 and selling at $120 certainly doesn’t sound like a lot of risk, does it?

The same holds for the covered call — you are the one holding the stock. The risk is that the stock goes down.

And that’s the risk every single stock-buyer takes. Wouldn’t you rather have some sort of hedge in place, one that helps you to lower your cost basis and, therefore, lower your risk?

2 Types of Covered Call Writers

This brings us to another critical point of covered call writing. There are two basic categories of call writers:

  • Those who use it as an income-producing strategy against stock they like, and
  • Those called "premium-seekers."

If you write calls against stock you like, then the covered-call strategy can be a powerful strategy.

Frankly, I never write covered calls against stocks I don’t like. After all, you are getting a little downside hedge and getting paid to sell the stock at a price you see as favorable.

If you like the stock, then you are willing to assume all of the downside risk. You would hold the stock whether options were available or not.

However, there are those who do not understand the downside-risk side of covered calls. These are sometimes called the "premium-seekers."

Premium-seekers look through the option quotes, find one that pays a high premium relative to the stock price, and then enter into a covered call.

Usually they follow up this trade with a comment like, "By the way, what exactly does this company do?"

If you trade covered calls this way, stop! I have seen million-dollar accounts fall below $10,000 doing nothing but covered-calls using this method.

Before you sell covered calls,

be sure the stock has staying power!

I remember one investor who bought 7,000 shares of a stock trading at $55 (to make matters worse, it was on margin or with borrowed funds).

He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. "Wow, that’s over 15-fold on your money!" he exclaimed. "At that rate, it would take less than 2.5 years to turn $1,000 into $1 million."

The trader bought the shares and wrote the calls, waiting patiently for his windfall to arrive. At options expiration, the stock was trading at just $4.

Yes, he did get to keep the entire $8 premium for the calls. But I’ll let you decide whether it was worth it!

There was a reason the markets were bidding up the options so high. They wanted someone else to hold the risky stock. The risk is that the stock falls.

A Word of Caution

You may hear people say that the risk of the stock going down in a covered-call position should not be of great concern.

They reason that you can always write another call after the first call expires and eventually "write your way out of the stock."

There is a big danger in believing this.

Covered calls realistically only give you one chance over the short term to write the calls.

This is not to say that you will never be able to write a second call against your stock. It’s just that you may have to wait a long time to do it.

Don’t Lock Yourself into a Loss!

Here’s another example. Say a stock is trading at $100 and you write a $105 call for $5.

At expiration, the stock is now trading at $75 — a $25 loss.

At this point, you decide to write another call. You’ll be lucky if the $105 call is trading for pennies that, after commissions, will net you zero.

How about selling the $80 call?

Yes, you will definitely get some money here; let’s assume another $5. If you write this call and the stock goes up to $80 or higher at expiration, however, you just locked yourself into a loss!

How? Your cost basis is $90 ($100 originally paid for the stock less two calls written for $5 each) … and you just gave someone the right to buy your stock for $80, which locks in a $10 loss.

Getting Out of a Covered Call

Many times investors write calls and regret it later when they see the stock trading for a much higher price. The good news is, with most U.S.-traded equity options, you can exit the trade at any time by "buying to close" the short calls.

Why would you do this? Generally if you have a renewed confidence in the stock’s ability to rise, you may want to consider closing out the short call.

Some investors, however, have trouble with this, as they feel they are taking a huge loss. This is absolutely false.

Let’s take a look at an example and see why a rising stock is better than a short call expiring worthless.

Say an investor has $40,000 cash with no other positions.

If she buys 100 shares of stock for $100, she now has $10,000 worth of stock and $30,000 cash. Now assume she writes a $100 call for $3 per share (or $30 per option contract).

This gives her $30,300 in cash for a total account value of $40,300.

Now assume the stock is trading at $130 at expiration, which makes the $100 call worth $30.

If the investor "buys to close" the call in order to not lose the stock, she must pay $30. Because she received $3 initially, she feels she has incurred a loss of $27.

But investors often fail to realize that the stock position is now worth more, too.

If she buys the call to close, she will pay $3,000 but now her $10,000 stock position is worth $13,000!

That’s because she is no longer obligated to sell the stock for $100 once she "buys to close" the $100 calls.

The stock is worth $13,000 and the cash is reduced to $27,300 for a total account value of $40,300 — exactly the same as before the closing of the call.

If you exit a covered call position by buying the call to close, you’re really swapping cash for an unrealized capital gain in the stock. In the above example, the investor lost $3,000 for sure in cash, in exchange for an unrealized gain of $3,000 in the stock.

So if you have new information on the stock and decide you want to keep it, buying the call to close is not the worst thing to happen. You really don’t lose anything when you buy back the call — but you may if the stock falls afterward.

Buying covered calls to close doesn’t destroy value; it just changes the value of the assets in the account.

If you decide to get out of a covered call position by buying back the call, be sure you are comfortable holding the stock at the current valuations.

Profit-and-Loss Diagram

In the profit-and-loss diagram, we assume an investor buys stock at $50 and writes a $60 call for $5. You can see the break-even point fell to $45 because they paid $50 for the stock but received $5 for the call, giving them an effective cost basis of $45.

Also, we see that for any stock price above $60 — the strike — the profit is capped at $15, which is the maximum.

Again, you must wonder why many professionals tell you this is the risk zone. It should be evident from the chart that the downside risk is that the stock falls.

Covered calls are a very useful strategy if used properly. If you use this strategy, make sure you are writing calls against stocks you would hold regardless. Selling Calls on a stock without having an underlying position in that stock is very speculative and dangerous.

Look for more upcoming articles on options trading. Understanding how options work can only help stock investors achieve better results.

Watching Your Chickens,

James DiGeorgia

P.S. Speaking of stock recommendations, I just sent a brand-new one to my subscribers. There’s still time to get in on itjust click this link here to see how. Plus you’ll learn why I think the Dow is heading to 30K … and the 3 mega-trends that are set to take us there!

Your thoughts on “The Short Road to Long-Term Stock Gains”

  1. I don’t think I could hold covered calls and sleep at night without taking 20% of that premium and buying further OTM puts to guard against black swans. As you pointed out, covered calls are deadly if the bad thing happens. There is no stock on earth I trust that much. Naked stock owners who write covered calls get peanuts for taking risks so massive 10 or 20 years of savings and profits could be wiped out in a few hours.

  2. Hello James!

    This is my first communication to you, so I should begin by saying, Welcome to the Weiss Group…
    I’m glad you’re here! 🙂

    I want to tell you that this article is the BEST I’ve read on writing covered calls!

    I’m no expert in options, but I have been learning and trading them since 2010, and just a year ago I began to learn how to write calls and puts (covered, of course), and have done several successfully on my own. Most were done on stocks I hold for G&I, and I do like them and plan to hold them whether I write calls or not. But a few of the puts I sold were simply for the premium (and to learn how it was done).

    I tried a professional service for a short time, and although I did want to buy the stock at a lower price, I didn’t want it at the strike called by the professional for that trade, so I ended up with a small loss after I was “put” the shares! After having tried some of these types of trades– some successful and a few not, I clearly see the wisdom of what you have explained so well in this article.

    Thank you so much for the clarity you brought to this subject. I’ve got a few excellent books on options, as well as a pile articles and explanations by various professionals, and your article is simply the best I’ve seen on writing covered calls!

    Many, many thanks,

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