[H988]How To Covered Calls

Warren Buffet does it, as do a lot of the large buy-and-hold investors, because it makes sense to generate income on stock holdings while you wait for them to rise in value, or to produce dividends.

It may not be right for everyone, of course, but if you're at all interested in generating 3% - 5% each and every month from covered calls, then you owe it to yourself to get as well informed about the various strategies as you can.

Now, if you spend any time searching the web for more information on covered calls, you have probably come across an article on Motley Fool called "Stay Away From Covered Calls".

The author, Dan Caplinger, makes the fundamental error of seeing covered calls as a 'gimmick' that doesn't really make much sense. His case is built on sand, and there are a few large holes in his arguments.

This Motley Fool article has been brought to our attention on a number of occasions now, and it's time to correct the errors Mr Caplinger has made.

1. In his Reliance Steel example, Caplinger says that the stock was stuck around $20 for most of 2004 and 2005 (you'll find a link to the 5-year RS chart below).

Assume the stock was 'stuck' for 20 months, and assume 5% a month in premium income for selling the covered calls. So you would be making $100 a month per option sold, every month for twenty months, for a stock holding of $2,000 per option. So, after 20 months, your stock is effectively free, because you've got back 20 x $100 in premium income.

2. All the time you're generating that income, you know the stock is going to break out of the range at some point - what you don't know is when it will break, and you don't know whether it will break up or break down! It's fine now saying it broke up, but it could have gone the other way or, indeed, done nothing at all.

3. Once it does break up, and you get your stock called away at a profit, there's nothing at all to stop you getting right back in again! In the same hour! Assuming the premium still looks good, and the charts look OK, this is what a lot of covered call traders do.

You'll also notice from the chart that it wasn't quite the smooth run from $25 to $60 that Caplinger implies. The first climb took the stock to around $50, and then it retraced to around $30 before it resumed its upward move. There's plenty of opportunity in there to make significant sums from covered calls in this period, too!

Caplinger is basically arguing for a buy-and-hold strategy, or what is sometimes called a buy-and-pray strategy, which means you can only make money when the stock goes up. (With dividends, maybe you make a bit if it holds steady, too).

With covered calls, you profit when the stock goes up, down or sideways! You have far more bases covered. Sure, you might miss a big move occasionally, but so what? As an investor, you are never wrong to take a profit, no matter what happens subsequently.

At Maverick Investor, our view is that...

(steady monthly income) + (no losing trades)

beats

(occasional big upward moves) - (money tied up in stocks going nowhere) - (some losing trades)

Every Time!

I can't comment on the tax, but there are entirely legal and above board techniques to trade covered calls without paying any tax at all.

As for commissions, I'm amazed he even mentioned them! They're so small now with online trading that that is almost irrelevant. OptionsXpress, as an example, quote a minimum of $29.90 for covered calls. Think or Swim are even lower, starting at $2.95 per option contract, and a $9.95 flat fee for stock trades up to 5,000 shares.

All in all, this is not the most impressively thought-through article I've ever read, and quite a disappointing drop in the usually high standards at Motley Fool.