Author Topic: Covered Calls  (Read 3375 times)


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Covered Calls
« on: December 16, 2014, 03:40:27 PM »

Financial Intelligence Report
The Newsletter for people willing to take control of their financial future

December 14, 2014 
Greetings Friends!
This is today's issue of the Financial Intelligence Report

Contributing Editors: Bob Rinear,  Robert Foster, Ted, Chuck and the gang!

Wall Street Lunacy donated by Janet Yellen, and Central Bankers the world over!

Part 1:  General Commentary
Part 2:  Market Commentary

General Commentary...
Covered calls

So now we know the basics about calls and puts and why we use them. Next we are going to explore the most overlooked tool that a investor can use--the covered call. This will be a long one folks because I am a real believer in using them in certain circumstances.

There are thousands of people who write (sell) covered calls as a profit making tool, there are "gurus" that teach how to become wealthy by using them, there are others who consider them a waste of time and yet others who don't know they exist. What the heck are they?

A covered call is a tool like any other option. It is a tool that we can use in certain circumstances to increase profits and that is why you are trading increase profits. So knowing they exist and using them correctly will indeed help your portfolio. Forget anything else you have ever heard about covered calls and remember this simple line... a covered call is a way to sell someone the right to buy a stock from you, a stock that you already own. Period. Okay so why is that such a good tool? For many reasons, let's look...

If you own a stock wouldn't it be nice to generate some income on that stock instead of just letting it "exist" in your account? Even if the stock has been performing for you, you can increase its performance with the use of the covered call. Do you have any stocks that you bought thinking they would rise but instead they have fallen and if you sold them you would take a loss?? Enter another reason for using covered calls. Actually there are a number of ways to use them, but for this installment we will explore just what the heck the mechanics of them really are.

If you don't know where to get options quotes, a good place to get them for free is at www.cboe. Now remember a covered call means that we are going to sell someone else the right to buy a stock from us that we already own. For this example, let's use Intel...symbol INTC. Suppose you have 1,000 share of INTC in your portfolio. You don't really wish to sell it but it would be nice to make "extra" money on it right? Right. So what you can do is this...sell the right to someone to buy Intel from you at a much higher price. For instance INTC traded Friday at about 36 dollars per share. Why not sell someone the right to buy INTC from you at 40 dollars per share in February?

If you look down the option quotes to February with 40 dollars as the strike price you see they are bidding 0.40. That means that you could take in $0.40 for each share of INTC you own simply by giving someone the right to buy it from you at 40 dollars per share by the 3rd Friday of February. That isn't bad because in our example you already own 1,000 shares so you would take in $400 dollars for placing the order. So for making a phone call, you have just received 400 hundred dollars.

What's the catch?? There really isn't any catch, but there are rules. If INTC announces some fantastic news and flies to 50 per share by will still have to sell it for 40. You would miss the huge run up. But since it is trading today for 36, taking in $400 for selling the option and getting the extra $4.00 per share from the stock's run up (the difference between where you have to sell it "40" and today's price 36) means that you would still make over 800 dollars on the trade. What happens if INTC doesn't make it to 40 per share?
Well, no one is going to buy it from you at 40 if it's trading on the open market for say...38 so guess what? We keep the $400 we got for selling the option and we keep our stock! This is why they are so attractive for long-term hold stocks. Once option expiration day passes, if the stock hasn't made it past the strike price we sold, we keep the stock, all obligations go away, and we can do it again! Not bad eh?

One thing you may consider a "catch " is this ... Once you sell that call, or in other words the right for someone to buy your stock at a certain price, you MUST keep ownership of the actual shares, just in case you have to deliver them at some point. So if you sell someone a call like in our example and the stock falls like a rock, you are still going to have to hold that stock. What you do at that point is this: "buy back" the calls you sold. If we sold them for 40 cents, and the stock crashes, they will soon be worth 10 cents, so you buy them back for 10 cents, cancel out the trade, and then you are free to sell the stock.

A lot of stock gurus teach how to make a killing writing covered calls, but I find most of it to be a bunch of hooey. I find they work best for adding money to a long-term portfolio, and for what I call damage control. Here is why ... The guys who set the options prices are wizards at it. When you find a ten-dollar stock that is getting 3 dollars for a call option, you can bet there is tremendous volatility involved in that stock. Too many "gurus" say, "buy that 10-dollar stock and sell the covered call...see you'll get 3 dollars per share instantly." That is correct, but what if the stock itself plunges to 5 bucks per share because the news that made the options so expensive turned out to be false??

You will end up with a stock you didn't want to own, and in a losing position. So you have to be very careful about buying a stock with the sole purpose of selling a call against it. Sure it will work at times, but overall it can be a losing proposition. We find it better to write calls against stocks that we own because we like the stock, not because we bought the stock for the rich option premiums we could get.

Writing a covered call simply means you are selling someone the right to buy your stock from you. Options are bought and sold in 100 share lots called "a contract" So if you hold 1,000 shares of something you could sell 10 contracts against it, and if you owned 200 shares of something you could sell 2 contracts. Your ONLY obligation is to hold the underlying stock past expiration day. You never have to add any money for extra expenses. Only sell a covered call that is "out of the money" In other words if you own XYZ at 50 don't sell the 45 call because it will be snatched away from you quickly! You would sell the 55, or 60-dollar call with the hopes the stock never makes it that far and you simply keep the premium and the stock.

So why don't more people utilize such a wonderful tool? Many still don't know they exist, some are frightened about the whole "options thing" and others have used them incorrectly. By that I mean...if the market trend is down, it is NOT a good time to sell covered calls.  In a falling market, the premiums on the call options are greatly reduced bringing in less bang for the buck. Often what happens is that as soon as a market starts to weaken, people sell covered calls, but then the "dip" is shallow and the market runs higher and they get the stock called away from them... a stock they wanted to keep. So only use covered calls in a flat to rising market and you'll do fine. 

Okay folks, we've discussed what options are, how they work and the three basic ways of using them. You can buy a call, buy a put or sell a covered call. Those three strategies will be more than enough for most people. From there you can indeed get crazy. You can create synthetic butterfly spreads, and condors and you name it. Forget all that until you've become a good options trader for a year.  That said, there's one more thing I'd like to talk about concerning basic options trades. That would be "naked" selling. Yes it is much more advanced, but it is an incredible tool, and not nearly as complicated as some of the more esoteric ideas. So on Wednesday, we'll talk about going naked. ( sounds naughty, no? Ha!)

The Market...

What a week it's been.  I think we'd best do a bit of chatting about where we are, why we're here and what might be next.

First we have to go back two Sunday's. On that particular issue, I was getting pretty convinced we were working up to a correction. We had sold off most of our long positions, taken the profits and waited to see if indeed a correction developed. The next day, which was of course Monday, the market did start to dip. We ended the day with the DOW off about 50+ points, and it looked like we might be setting up for one of our typical 3 - 5% corrections.

But NO. They came in the next day with guns blazing and reversed the dip and added 50 more. From Wednesday - Friday they pushed and pulled the market to the point where on that Friday, we came just 9 points shy of DOW 18,000. It was perverse watching it happen because there was literally NOTHING to support the move. Sure they said it was the "wonderful" jobs report, but of course the jobs report was a manufactured piece of fiction. For some reason they decided to dump the most "seasonal adjustments" on the report that we've really ever seen.

Everyone was of course lulled into complacency. The market was back to grinding higher every day and they all went into the past weekend figuring it was up, up and away. Well, that plan went to hell in a handbag. We plunged Monday. We plunged Tuesday. We plunged Wednesday. We got a bizarre bounce on Thursday that petered out, and then Friday we fell over 300 points.

I am NOT going to say I predicted it. I expected this selling to hit the week before and they short circuited it. But they didn't "end" it; they simply pushed it back a bit. It hit with a vengeance this past week.  So, why the big dip? And why so deep? Don't forget folks, a week ago we were inches away from DOW 18K and Friday night we were looking at 17280. That's pretty much 700 points, 4% in five days. That's heavy.

The old theory is that the market knows all the information there is in the world at any particular time. So prices are based on all the knowledge at that time. Yet there's always been the "black swan" event that lurks. For instance if the market truly knows all things, it wouldn't have been "up" ahead of 9/11. It would have plunged for days ahead of the event. Yet it didn't and then the event hit and the exchanges were closed for several days, opening considerably lower.

The Black swan had hit. So, the fact is the market doesn't know everything. There's always that "outside the bell curve" fat tail event that can cause problems. Well, oil prices are the current slow motion black swan. Now I'm not at all saying that all this drop was because of oil prices...I'm saying the market was ready for a correction, and the oil price slide became the proper excuse to let it happen. For all the market's supposed collective wisdom, NO ONE predicted in June when oil was 110 a barrel that it would be 59 by December. NO ONE.  But there's more in play than just oil. This week we very well may see the Fed's remove the language about keeping rates low for a "considerable" time. That got a lot of traders squaring off positions ahead of that.  Again, oil was a massive contributor to the selling, but not the ultimate reason.

So we've fallen 4% off the highs. We are now just a handful of points away from the 50 day moving average on both the S&P and the DOW. Will they stop the bleeding there? It's probable, yes. I could see a bit of a dip taking us below the 50's for a few hours and then the "comeback" rally that saves the day.

But why would we stage a comeback? Are jobs really that plentiful? NO. Is the economy really humming along like they say? NO. Is the nightmare that is indeed Ukraine all better and the US and Russia are now best friends forever? NO. There is absolutely NO fundamental reason for a move back up into year end. But there are "reasons."  Not fundamental, earnings backed, sales backed reasons... just baloney reasons.

One is that historically the past week we just had is often the worst week in December. Looking back through history, the week coming is historically one of the better weeks of the YEAR.  So we've got seasonality in favor of a reversal higher. Next up, we've got a lot of fund managers very much lagging the indexes this year. They'll want to try their best to brighten up their portfolios, by buying leadership and praying it runs into year end. Thirdly, we've got the support levels of the 50 day moving averages here.

My guess is that they rescue the market and push us back up in a year end Santa Claus rally of sorts. We've fallen 4%, and it's VERY rare to see an actual 10% correction in December.  While I believe the market deserves to fall another 1000 points, it most probably will not. So we began to nibble on a few things Friday in anticipation of a strong bounce. Despite the massive sell down, there were a few stocks that showed remarkable relative strength on Friday, such as TTWO, DECK, and TJX. We are actually in two of the three.

So that's our guess for the week folks. I could see a flash dip hitting early and then a Vee recovery that starts us on a path to higher stocks into year end. Lets see if we get it right.

PS.. If you'd like to see the exact stocks/options/metals/ETF's and 401K moves we will be looking at for this week, please consider becoming a member of the "Insiders Club" located here:


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