The over-hyped and time-worn strategy of “selling covered calls” does have a SEXY ring to it. The idea is that you can take a stock (that you’re already happy to own) and take INcome while you sit on it… well, it appeals to a large amount of college educated, middle class to affluent, retirement age guys and gals.
Too bad it’s mathematically flawed and will end up taking all your savings if you play it long enough.
WHA..?
Yeah, I said it. And unless the attendees to my free semiweekly options trading education webinars are LYING… it’s happening too fast to too many people. I’m not happy about it and am trying to help people free themselves of the two biggest problems about trading with covered calls…
…but, that idea of getting PAID while you wait still mournfully gives its siren call.
In this post I’ll share ONE of TEN “Income Method” adjustments that I make to a protected trade, to take out a leeedle bit o’ money while at the same time leaving the upside potential for growth wide OPEN.
Here’s a recent trade I showed Fission’ Members (my online ongoing education membership). Here’s a simplified version of the setup:
I own 200 shares of CTSH, protected by put options. On 12/27, the February 2011 $72.50 calls are selling for $3.90 and the February 2011 $75 calls are bidding at $2.45.
Income Method #5, “The Money Net”, goes like this… sell two $75 callsagainst the 200 shares for $2.45 each, raising a total of $4.90 premium. Use some of the proceeds to buy one $72.50 call for $3.90. Immediate result? $1 total credit received, while holding 200 shares and one long call. Against the 200 shares, 2 long calls have been sold at the $75 strike.
Say we hold all the way until expiration. If CTSH is below $72.50, all calls expire worthless and we get to keep the $1 credit.
If CTSH closes at, say, $73.50… then the $75 calls still expire worthless but the $72.50 calls are in the money by $1.00. We can sell the call and pick up $1.00 on expiration Friday in the closing minutes. The second$1.00 credit is “CAUGHT” in ‘The Money Net’! So that’s $1 at the beginning, plus $1.00 more later on for a total of $2.00.
But that isn’t what happened. Actually, CTSH went up by more than that… on expiration Friday it was apparent to me that the short calls were going to call away all 200 shares of the stock. I don’t want this to happen, so I pick up 100 shares at $76.48. Now watch this…
I’m now holding 300 shares CTSH and it’s expiration Friday. I’m holding one $72.50 long call and have two $75 short calls, and I’ve gotten a total $1 credit. IN the middle of the night, my broker will “automatically exercise” my right to buy 100 more shares at $72.50. That brings me up to 400 shares of stock, but not for long.
200 of those shares get delivered in that same way… in the middle of the night, by automatic exercise… for $75 apiece. That leaves the original 200 shares and the put options protecting them, plus a nice little bonus of $2.02 “caught” in the ‘Money Net’!
Complicated? Naw, just work it out like so, going backwards: Buy 100 shares for $76.48 on expiration Friday. Buy 100 more in the middle of the night for $72.50. That’s $148.98. Now take off a dollar from the “Money Net” trade… total spent of $147.98, for 200 shares, which shares are delivered for a total of $150.00. The $2.02 difference is “banked” and we get to keep the original 200 shares we were holding.
So the ‘long’ and the ‘short’ of it 😉 sorry, couldn’t resist the trading pun… is that I’ve been paid $2.02 to hold on to a stock that’s run up past the strike price of the short calls I’ve used to generate that premium.
Try THAT with covered calls 🙂 My Income Method #5: “The Money Net” trade caught some bank while leaving the upside open. It far outweighed the benefit of selling a “plain vanilla” covered call. Had I simply sold two calls at $2.45 apiece, then bought them back on Expiration Friday for $1.50 or so, I would have collected less ‘net’ premium. But the biggest problem would be that I would also cap the upside if the stock had blown its doors.
The biggest question I get when I show folks this Ratio Call Spread trade, done within the context of a married put, is this: “Can I do this in an IRA?”
Yup. And you’re likely to do a darn sight better knowing this and the other nine Income Methods than with just selling covered calls.
In the next installment I’ll show how this particular trade made for unlimited upside in case of a big run up, something that selling covered calls does not do. Til then…
Happy Trading,
Kurt
P.S. Hey, I do a free weekly options trading webinar at 12:00 noon Tuesdays and Thursdays. The March 1 and March 3 editions will have this trade, only more detailed and using PowerOptions tools for analysis. Come and see!
I’ll also show how I’ve made the position “BULLLETPROOF”, meaning that the adjusted cost basis for both the stock and the puts protecting them… is now LOWER than the strike price of the put. So I can run the “Money Net” again and potentially take out more premium than a covered call, but CAN’T lose if the stock goes down.
Also, the upside is unlimited in the case of the stock going for the moon. You can’t do that with plain vanilla covered calls, I guarantee it! Come to www.radioactivetrading.com and look to the right for registration information for the March 1 and March 3 webinars, no charge.
I'm Kurt Frankenberg, and I have discovered how to truly put the odds on the side on the individual investor.
I’m now holding 300 shares CTSH and it’s expiration Friday. I’m holding one $72.50 long call and have two $75 short calls, and I’ve gotten a total $1 credit. IN the middle of the night, my broker will “automatically exercise” my right to buy 100 more shares at $72.50. That brings me up to 400 shares of stock, but not for long
why do you need to do this “buying the stock” but not for long.. you will make the money by having this long call which is in the money.. its the same as buying the stock and exercising the long call.. why go thru all this…
Hi Mendy,
Please see my reply to Bill above… it pretty much answers the same question. Yes, you can simply buy to close the short calls and sell to close the long call and still come up with a profit. I chose instead to pick up 100 shares of stock and let ‘automatic exercise’ do its thing.
Long story short… you can manage the position however you like but my intent was to show this “Income Method”. The call ratio spread, done within the context of this married put trade, brought in much more than a covered call play, while leaving the upside open.
I’ll do a follow-up on this play which will do a better job of illustrating just that fact: that a properly done “Money Net” Income Method leaves the upside open. Thanks for your question!
Kurt, to make a long story short, I am getting geared up to trade Radioactively, but I have a few long 2012 LEAP call positions covered by 2012 LEAP short calls. The problem is that the underlying stocks are trading higher than the short LEAP strikes. I have a fair amount of capital tied up in these positions. Before, I move on to trade with long stock as per an RPM, is there a way to repair these positions either now (preferably) or at expiration in January 2012 with Income Method #5? Your assistance is much appreciated!
Hi Richard,
I’m going to ask that you pose a question like this to support@radioactivetrading.com. It doesn’t have anything to do with this particular post. Please be as detailed as possible. Thanks!
Why not just – on one ticket, sell the 72.5 call for 3.98 and buy th two 75s for 2.96 (1.48 ea) and be net credit 1.02. Plus the original 1 credit brings you to 2.02 (same net). Granted, there may be some pennies of premium and/or spread at the last minute, but that should be swamped by the exercise and assignment charge. Also, there is no risk over the weekend! ( it’s possible you could NOT be assigned and be long an unprotected 100 shares upon bad news after market)… also, you need the money ($7,648) and/or margin ($3,824) to buy the 100 shrs. Not sure what would be needed for the assigned shares since they are also being called (maybe just the $2.50 delta in strikes).
Well, no reason you can’t do that. In fact, that’s my usual M.O. In the interest of showing you what I DID do, however, I listed each move. I did in fact buy the stock in order to avoid paying extra bid/ask spread. Good point though about the bad news after market!
Kurt, help me out, I’m confused about something.. I’m calculating that your profit should be $3.50, not $2.02. For simplisity sake, lets pretend you didnn’t buy the extra 100 shares the night before expiration.
so you made a net of $1.00 for selling the 2 75 call options and buying the 1 long 72.50 call.
Since the stock closed at expiration above the 75 short call, you would make the difference of the strike prices (75-72.50) which equals $2.50. so when you add the 2.50 plus the 1.00 I got a total profit of $3.50.So again, assuming you did not buy the extra 100 shares, when everything settled, you would be left with the long protective put.
Let me know if I’m forgetting something. Thanks!
Hi Mark!
Yes, you’re right… my profit from doing the “Money Net” IS $3.50. However, since I did want to keep the 100 shares that otherwise would have been called away, I took AWAY from the profit. In this case, that meant spending the equivalent of $1.48 to keep the stock for other plays.
Thanks for the Q!
Happy Trading,
Kurt
Okay, but that ability to hold onto the stock in the event of an upswing comes at a direct cost. Your trade is to write 2 calls against your 200 shares (nothing more than 2 covered calls), but then you add in another leg, which is the purchase of a long call. The problem that you don’t mention is that buying that call cuts directly into the premium that you collect. Instead of taking in $4.90, you only take in $1. The premium paid for the long call is the direct cost of keeping open your upside, and it’s a pretty steep cost, at least in your example.
So, using your three possible outcomes, let’s compare the Money Net (“MN”)trade to just writing the 2 covered calls (“CC”).
If CTSH is below $72.50, all calls expire worthless under either trade. MN nets you a $1 credit, but the CC would have gotten you $4.90, nearly 5x as much.
If CTSH closes at $73.50, the 75 calls expire worthless under either trade, and in the MN you can sell the 72.50 calls for around $1. MN nets you a $2, but the CC would still gotten you $4.90, nearly 2.5x as much.
It isn’t until the stock gets above 75 that the MN gives you any benefit at all, and even then, it’s a limited benefit unless it just flies right by 75. You don’t give the price of CTSH at the time of the trade, but presumably all of the calls were OTM, so let’s assume it was at 72. If CTSH closes at above 75, the CC trade keeps the $4.90, plus it also gets the profit from the movement of the stock up to $75, so $6 more (remember, we have 200 shares), for a total of $10.90. Now, the MN trade gets $2.02 in premium, and it also gets that $6 in stock price increase, for a total of $8.02, plus it gets any additional amounts from further increases in the stock price above 75. But that additional gain doesn’t catch up to the extra premium collected in the CC trade until the stock hits at least $76.44–that is the first time the MN breaks even with the CC!
So, as you sit down to compare these two trades, you have to decide how likely you think it is that the stock will go up from 72 all the way to 76.44 (6%) in 30 days or so (the time from the trade date to expiration). If the stock doesn’t go up at least that much, the CC is the more profitable trade. The CC is also far more profitable if the stock stays put or goes down.