Courtesy of Rev Todd
What is the safest way to invest with an IRA? The housing bubble (which should really be called an avalanche, since bubbles don’t sound dangerous) challenged traditional notions of safety. I remember reading several articles in 2007 about how safe REITs were, and they paid double digit dividends at the time. “Everyone pays their mortgage, right? It’s like investing in the American Dream!” Financial planners focused on asset allocation strategies, blending domestic and international stocks, bonds, and advocating that being spread out everywhere insured that you would gain in some places and lose in others, but over time you should make 10 percent a year.
Then we find out that the first decade of the 21st century was a complete wash in the stock market. In September of 2008, do you know how many of the several thousand mutual funds were beating the market? 17! And five of those funds were run by the same woman! Wish I could remember where I read that. So I could have put all my money in a couple of ETFs and done better than a mutual fund and avoided all the fees. So much for safety.
Where do you feel most safe investing now – stocks, government or corporate bonds, gold, real estate, commodities? Wrong on all the above. Chocolate is the best performing asset over time. Do you think Warren Buffett invests in Hershey and Cadbury because he has a sweet tooth? You could have skipped the dot.com and housing avalanches and retired with a pile of Hershey’s kisses, which taste much better than gold.
Here’s my answer the question of safety. Invest with options! People forget that options are designed to hedge against risk, not as speculation tools. My Grandfather ran a farm, feed store and trucking business in a tiny Iowa town. When I was 13 years old, he taught me about corn and soybean futures. He left me in charge of the feed store and a telephone number in Chicago to call if any farmers came in to hedge their crops for the fall. I drew up three contracts that afternoon for small farmers looking to lock in their grain prices while the market was high and they had crops in the field. They were happy buying the options, but I noticed the guy selling the options – my Grandfather – had the biggest truck and wore a Rolex to church. This experience is why covered calls are my primary investment strategy.
Many people use long-term covered calls in their IRAs but may shy away from monthly covered calls as too risky. Writing long-term covered calls provide a larger downside protection over the long haul, but I think writing monthly covered calls can work well with the right risk management strategy. Risk management is the key. Safety is a meaningless term in investing and in life. My grandfather’s family escaped pogroms in Europe and found even Switzerland not safe enough. He lived through the Great Depression and spread his bank accounts to about 10 banks. Farming teaches you that disasters happen. There will be droughts, floods, tornadoes, grasshoppers, animal diseases and terrible crop prices. It is not a safe occupation. The question is: what will you do when disaster threatens your livelihood? I take the same approach to investing. Never assume that anything is safe. Assume that things can and will go wrong and have a risk management strategy in place.
Here are the things I do to manage risks on monthly covered call writes. First, you need to know why your stock is dropping. Is the whole market dropping or just your stock? Where is the risk? Is it with only your stock, the economy, or is your stock just trending to its support. Let me say a few things about each of these types of risk.
If your stock is going down like someone just attached cement shoes to it while the rest of the market is fine, get out! It’s done for and not coming back in time to save it. If the company that looked rock solid suddenly fires their CEO, the CEO is dumping stock or they just poured a few million gallons of oil on most of the Gulf Coast pelican population, dump it immediately. Maybe some analyst who can’t find his rear end with both hands gave your stock a downgrade. Don’t be stubborn to prove you are right. Don’t do any fancy options moves to save the day. Unwind the trade and move on. It’s OK to have picked a stock that doesn’t work out and live to invest in something else. It’s no good to be right about a stock in the long run but broke in the short run. These are monthly writes. When in doubt, cut your losses.
What if the market as a whole is falling? When my stock is falling less than the market as a whole and I feel it is a good stock, I may roll down or down and out to the next month. This allows me to capture more premium and possible make money without selling out my position. Rolling down a call deserves a complete article, but for now I would say, first check to see if the roll down can be done leaving the stock profitable if called out. I wrote monthly covered calls all through September 2008 onward while the market bucked like a bronco. The initial collapse was sudden and it was impossible to get out at cost basis. When I saw how high options premiums had become as the VIX went through the roof, I decided to roll my calls down and out. In some cases I made more money on my covered calls than I first intended! As I noted in a previous article, I made 10 percent on PBR in late 2008 even though the stock dropped 15 percent during that time period. I pulled out my old spread sheet and see that I lost 26 percent on October 2008 calls (written in September). I made 10 percent back in November and December, closing 11 of 14 trades profitably. I made 15 percent each of the first two quarters in 2009 and had all my money back. I wonder how many people have all their money back into their IRAs now, using more “safe” strategies than monthly covered call writes.
Not all downturns are disastrous Black Swan events. Some downturns are just ugly ducklings as the market paddles back and forth between support and resistance. The most important thing I do is keep track of my cost basis. If a stock is nearing my cost basis I have a decision to make, either get out or roll down. This is why I try to write my in-the-money calls with my cost basis below support at a moving average. If the stock is snorkeling underwater rather than shipwrecking, I will watch it a couple of days and see if it finds support and moves back up. If the stock seems to find support, I may even trade the call, buying it back when it trends sideways at support and re-selling it when the price recovers. But if the stock breaks cost basis and drops to the next level of support, I’m done it. The ship is taking on too much water to bail out and I’m riding home with the Coast Guard.
I hope this basic primer gives you and idea that you can successfully manage risk with monthly covered calls. I also follow some basic virtual portfolio guidelines. I keep my positions to about 10 percent of my total assets, and I always cut losses so that I never lose more than one percent of my virtual portfolio on any one position. I also don’t load up too much in one hot sector and keep some diversity in my virtual portfolio. But the best advice I can give from my failures is avoid getting greedy and follow your own rules. That is why I post my basic rules with each trade alert to see how that stock stacks up. Following these rules on entering a covered call makes risk management much easier. In the coming weeks I will highlight why each of these rules is important. Next week I am writing on the importance of trading with an edge. I will also be posting some October trades if the market stays favorable, so stay tuned.
