How I Finally Reversed the (BAD) Luck I was Having with Covered Calls – Part ONE

‘Morning, all.

It may not be morning when you’re reading this, but it’s morning for me. Like many folks that have freed themselves from the rat race (a la Forty Hour Work Week), I’ve made the grueling commute from bed to my office across the hall.

Ahh… Working in my jammies is cool ūüėČ

4:30am and the muse strikes. Mrs. Frankenberg, on the other hand, is NOT amused.

Today’s post is the first in a series in which I’ll show how I “Finally Reversed the (BAD) Luck I was Having with Covered Calls”. I think it’s overdue for a lot of reasons… but mostly because if YOU are still doing this¬†overrated¬†strategy, you deserve to know there’s a better way.

So here goes.

Back Story

First, a familiar story. In the late nineties, I was doing okay with the “Covered Call” strategy for hedging stock. By picking up a fairly volatile stock and selling near-term calls against, I was getting really decent premium. Buy a stock, sell a call, get called out at a quick profit. Lather, rinse repeat.

Ah.. but everyone’s a genius in a bull market ūüėČ

A Nagging Question

Even before¬†somebody “got hurt real bad” (hiya, Russell Peters)… something bothered me a bit. Often, when I was called out (meaning, when the stock I was trading got yanked away from my account because I had taken on an obligation to deliver it at a predetermined price)… my stock actually moved up MORE than the amount that I took in in premium from¬†selling¬†the call.

In other words, I woulda¬†made more money if’n I had just held on to the stock and sold it on expiration Friday. Rather than¬†accepting a small premium¬†now, then having to sit on the stock for a couple of weeks or months while it was deciding where it was going… THEN having to part with it for a pittance… I could have made the REAL money by not obligating myself to sell at a lower price.

Y’know that popular trader’s maxim, “Cut your losers short… let your winners run”..? Well, the thought¬†kept nagging me:¬†Kurt, exactly¬†HOW are you¬†letting winners run? Every time you have a winner on your hands, seems that it’s gone before the big gains ever happen.

Still… like I said, everyone’s a genius in a bull market. And I was doing okay… hell, MORE than okay with the gains I was getting from the covered call plays, so I kept right on doing ’em. Buy stock, sell call, get called out. 3-5% profit. Lather, rinse repeat.

Until… the BOMB¬†dropped.¬† ūüôĀ

Disaster

Yup. A stock I had¬†put everything¬†into at about $17 a share.. on MARGIN… missed its FDA approval.¬† My broker called at 7:45 am… 9:45 on the East Coast… and said “XYZ opened at $9 and headed down from there. They’re gonna ask for a margin call, Kurt. What do you want me to do?”

We tried a few limit orders but my stock kept plunging, leaving them unfilled.

“S-sell.” I stammered. “Sell for whatever you can get.”

I ended up using a market order,¬†getting out with a net loss of JUST ABOUT EVERYTHING…¬†and the damnable misery of it was that my stock climbed right back into the same range four months later. Its big procedure eventually got FDA-approved. Had I made the margin call, I would have been just fine.¬†In the words of the immortal Maxwell Smart, I “missed it by.. that much.”

Sigh.

Well, a few factors combined to get me into a foolish position, and come out of it with nothing to show but bruises from my hard knocks. I never should have been using margin, but then again I shouldn’t have been in covered call plays at all, either… not if I was bullish on a stock.

Breakthrough

After licking my wounds and regrouping a bit, I concluded that it wasn’t my covered call guru’s fault… wasn’t my broker’s fault… wasn’t even the guys on the other side of my trade that made a killing (of ME) that were at fault.

Kurt Frankenberg was to blame.

And, if Kurt’s behavior got Kurt into trouble… why then, Kurt can change his behavior.

Looking at all the factors that got me into a silly position in the first place, I decided to reverse them all.

By October 1, 2002 I had put together enough capital to trade again. Only THIS time, rather than using a short call to hedge my stock (a covered call play) I did the reverse: I bought a put option that protected my stock (a married put play)… and protected it for more than two years.

I’ll get into the particulars of how I do my particular brand of married puts in the next post. But suffice it to say that my method affords greater protection for a longer period of time than the standard method. Here’s what AMZN looked like, a year after I got in at $16.09:

Bottom left is entry at $16.09. There's still a year left of 'insurance' on this position but it's clearly profitable

By reversing just a few things about my trading plan, I was able to turn the results around! Here were the critical “no-no’s” I¬†vowed never to practice again, therefore allowing me to get into a good number of trades like the one pictured above:

Hubris versus Confidence… something was nagging me all along while I was still stuck in the ‘covered calls zone’.¬†But I forged ahead anyway, looking at the few short term gains I had made as reassurance that I was on the right path. Ouch… went totally broke. Never again. The change happened when I decided to research my “options” a lot better before trading again.

Borrowing Money to Trade… If being careless is bad, using borrowed money carelessly is worse. That’s what margin is. Anyone wishing to mortgage their future by paying interest on losses… losses to which their exposure is multiplied¬†exponentially… should look into margin. It’s an excellent way to get hurt.¬†Everyone else¬†should steer clear.

Using a Flawed Strategy… The covered call strategy is a reliable way for brokers, market makers, and seminar gurus to line their pockets. It’s an algorithm that places the odds in everyone’s favor… EXCEPT the trader that it’s supposed to benefit.

Don’t believe that last one? Ahh, you drank the Kool-Aid too, didn’t ya?¬†Covered call trading is the first thing they’ll qualify you for if you apply to trade options as a newbie… but I’ve interviewed live audiences twice per week for five years now. I’ve yet to find a single live person that’s consistently getting the returns they talk about in the seminars and promotional materials.

Scary? Mmm-hmmm. Surprising? Nope. After all, using a covered call to hedge your stock ownership violates the first and most sacred rule of trading: Cut your losers short and let your winners run. More often, I’ve been told that covered calls serve as a sorting machine, taking winners out of¬†a seminar attendee’s¬†account…¬†while leaving the losers in it.

The New Me

After making the decision to take out insurance policies on my stocks… instead of accepting tiny tips for holding them… my trading account changed dramatically for the better. NOW, the name Kurt Frankenberg is synonymous with married puts. Once I decided to reverse my destructive¬†behaviors described above… trading with hubris instead of confidence, ¬†using borrowed funds to multiply my folly, and that folly being the covered call strategy… things began to turn around for me. BIG time.

But I still had quite a few things to learn. In the next post I’ll tell you how I ‘learned to shop’ for the BEST deal for low risk. high-potential return trades.

Til then,

Happy Trading!

Kurt

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About Kurt Frankenberg

Kurt Frankenberg is an author and speaker about entrepreneurship, martial arts, and trading the stock and options markets. One of several "Biznesses" he founded as a teen, The Freedom School of Martial Arts, has been in continuous operation since 1986. Kurt lives in Colorado Springs with his wife Sabrina, German Shepherd Jovi, and his ninja cat Tabi.