A Substitute for a Covered Call
Retirement investors are faced with fewer choices when it comes to trading options. In any account, selling naked options to generate premium ties up a lot of capital as the naked options have to be cash secured. In retirement accounts, one may sell naked puts, but they must be secured for their full value, and naked options are generally not allowed. Considering these restrictions, a strategy used by many investors in retirement accounts is the covered call – buy the stock and sell calls against it to regularly collect income. If the stock pays a dividend, this adds to the income.
In a standard account, broker-provided margin can be used for the stock purchase, reducing the capital required to purchase the stock by half. For example, buying 1000 shares of GE at $20 will tie up only $10K in a standard account (without portfolio margin), but in a retirement account, no broker-provided margin is available and therefore the same GE purchase would require the full $20k. This means that returns as a percentage of capital invested can be twice as high in a standard account. What if we could generate the same kind of returns in a retirement account and still participate in the upward movement of the underlying stock? We can by using diagonals with LEAPs as a stock substitute. LEAPs are long dated options (18 to 24 months) that decay very slowly until the last months before expiration.
How do we structure a diagonal?
As with the covered call, we need an instrument to sell premium against. In the standard covered call, you buy the stock. In our case, we will buy LEAP calls expiring in 18 to 24 months. For example, imagine that I like Oracle long term, I will start by buying 10 January 2013 LEAP calls with a $20 strike. They sell for around $7.35 so I need $7350 to get started. We’ll get to how to choose strikes later. Oracle trades at over $25 right now, so 1000 shares would tie up $25K in my retirement account and $12.5K in my margin account. So this approach frees between $5-15K to pursue other investments! But I also pay $2.15 in premium for that! But the longer dated options decay a lot slower than the short dated one and this is the principle behind the trade – we buy slow decaying options and we sell fast decaying ones against them.
Next, we will sell short dated calls against the LEAPs. For example, the September $25 calls currently trade around $1.68 of which $1.48 is premium. They expire in 25 days. You end up with the following position:
Figure – Profit graph for selling September $25 calls against January 2013 LEAPS
In this case, you have about 10% of downside protection and close to 30% protection on the upside. Determining the strike to sell will depend on your outlook for the stock between today and the expiration date. The ideal scenario in this case is for Oracle to finish around $25 as this where we collect the most premium. Taking into account the decay of the LEAP, we would earn about $1400 against the initial investment of $7350. This is obviously an ideal scenario and things don’t usually work out that well! And the VIX is quite high as I write which also boosts options prices.
Our Approach
This strategy is not new and has been employed by others. But in many cases, aggressive positioning and a poor choice of the underlying stock leads to problems. Here are the differences in our approach:
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Stock choice – Many are attracted by volatile stocks such as Apple, Google or Amazon for this setup because they have juicy premiums every month. But the reason the premiums is high is that they are quite volatile. No amount of premium selling can make up for stock being cut in half! It would be wiser to stick to less volatile stock, trading the lower yield for more capital security. It is of course also possible trade an index to further reduce volatility.
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Strike positioning – To enhance return on investment, we could choose an ATM strike. For example, in the Oracle example, the January 2013 $25 Call trades for around 4.50, lowering our initial investment. But they also have a lot more premium than the lower strike option, premium that has to be paid for somehow. Our approach is to buy LEAPs around support areas. Looking at a long term chart of Oracle, we can see that there is good support around $20 for example. Actually, the stock remained above $15 even in during the turbulence of 2008. Buying strikes far above a natural support area could be asking for trouble.
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Timing – It is almost impossible to pick tops and bottoms, but we can still favor stocks that are on an uptrend rather than a downtrend. Appreciation of the underlying LEAP is also part of the profit picture. It is still possible to be profitable selling premium against a stock going down, but as I mentioned above, no amount of premium sold can make up for the type of damage done in the market over the last 3 years! So, in this case, we could choose to pick stocks whose 50 DMA crossed above their 200 DMA, or any other indicator you like to use. Once again, we are not concerned with perfect timing as this strategy allows for price movement in either direction as long as such moves are limited. Just as we have to be careful opening a position, we also need to try to time our exit. In some cases, we could ride the LEAP to expiration, but in others, we’ll have to cut our losses, especially in a volatile environment. The same indicator used for entries could be used for timing exits. Timing also important when selling premium as you want to avoid the earning periods for example. Higher volatility leads to better premiums, but also higher risk!
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Profit targets – A good home run hitter will hit 40 a year, but will also strike out 200 times! We would rather hit singles every month and strike out rarely! Targeting around 5% a month is the prudent approach. It is not as sexy as 10%, but it is also less risky. Making 10% a month and wiping out once a year is not an investment plan, it’s gambling!
Trade Adjustments
There will be months where we will need to adjust the trade – rolling short calls lower to capture more premium or closing the trade and capturing early profits. In our Oracle example, suppose that over the next 30 days the stock rises to $26 for example. We sold the 25 calls so by expiration, these calls would be exercised, in this case and depending on timing and indicators, it might make sense to collect our profits by closing the trade. In cases where the underlying stock would head marginally lower (for example $24 in this case), we could also roll the calls lower and try to collect more premium.
The idea is not to day trade these positions as commission could also eat into your profit margins, but we need to be nimble in order to sell as much premium as possible.
Managing Risk
Just like any other investment strategy, this one is not without risk. As I mentioned above, no amount of premium selling can make up for stock caught in a fast downtrend. Even the best managed position will lose money in that scenario. On the other hand, the capital at risk will be lower than if invested in the underlying stock. In our Oracle example, if the stock were to plunge to 15 overnight, the stockholder would be facing a $10K loss while the LEAP holder only 2/3 of that. Not much of a consolation though! This is why position sizing is also important, as well as strike choices and timing! But were you to choose to risk 10% of your portfolio on this strategy, using 10 underlying securities, each of the securities would only make up 1% of your entire portfolio, a manageable risk! And hedges are of course recommended using the proceeds from the call sales!
Advantages and Disadvantages
The obvious advantage over covered calls is the amount of capital needed. In general, only about 40% – it’s like creating your own free margin (remember, margin as a price, your broker does not lend you money for free). Returns on investment are also higher since the premium collected will be higher as percentage of the capital invested. If things go well, you end up with a free call that can be exercised against a higher priced stock if ownership of the stock is desired.
On the other hand, even if the stock does not go to zero, you could still lose the entire capital invested with nothing to show for. No doubt a smaller loss than the stockholder relatively speaking, but an absolute loss nonetheless. And if the stock rises to quickly you could face additional transactions if the short calls get exercised – remember, you don’t own the stock! Or end up having to buy back expensive calls…
Many will find this strategy boring. The biggest decisions might be when to enter or close a trade! But boring is nice sometimes! In addition, some stocks and indices trade weekly options. If you need to trade more often to satisfy some need – by all means pick one of them and sell options every week! Commissions might eat into your margins, but well timed sales could also enhance your profits.
Example:
On September 29, 2010, Oracle stock’s 50 DMA crossed over the 200 DMA, giving us a bullish signal (I use moving averages in this example for simplicity, but other indicators can be used). There is a lot of support around $20.00 so we decide to purchase 10 January 2012 $20 calls as the anchor for selling premium. These calls sell for $8.35 while the stock sells for $27.17, so that is about $1.18 in premium. Since we are bullish on Oracle, we will sell higher strike calls and sell the November $28 calls that expire in 51 days for $0.66 wiping away half the premium. The initial investment is therefore $7690 ($8.35 – $0.66 plus commission of course). Moving forward to expiration day on November 19, the January 2012 calls are now worth $9.02 and the November calls only $0.15. Our profit for these 51 days is $1180 or 15% of the original investment.
This trade worked well because the stock went up as planned. Let’s look at an example where the stock does not go up and what happens to the trade then. On October 6, 2010, we had a bullish cross with the 200 DMA of ABT (Abbott Lab) crossing over the 50 DMA. The stock trades at $51 on this date. ABT is not a very volatile stock (good) but it does pay a nice dividend so it is not the perfect candidate for this trade as we do not collect a dividend holding the LEAPs calls, but it makes for a decent example. The stock trades at $52.98, so we enter the trade by buying a January 2012 $45 call for $9.32 and we sell a $52.50 November call expiring in 44 days for $1.28. The strike is ATM because the stock is not volatile and we do not expect fast movements from the stock. Moving forward to November 19, 2010, the expiration date, the stock has moved down to $47.40, losing $5.10. Owning 1000 shares would had yielded a $4740 loss. How did our trade fare – the January 2012 $45 calls are now worth only $5.00, but the calls we sold expired worthless, offsetting the loss by the full amount of the sold call. With 10 contracts, our loss totals $3720. Selling premium has help cushion the loss. To be fair, these same calls could have also cushioned the loss in case shares are owned, but the total investment needed in our case was only about $8000 against $52,000 for the 1000 shares.
What is explained above is a worst case scenario. There are many steps that can be taken to minimize the loss – the simplest one being setting stops on all the options (short and long). A month after we initiated the trade, the stock moved below its 50 DMA which would have been a warning sign that weakness was around the corner! If we were to keep the trade on, we could adjust the calls we sold. For example, on the day after the stock crossed below its 50 DMA (November 2), the $52.50 calls were trading for $0.19. At that time, we could have bought back these calls and sold the $50 calls for $1.34, generating another $1.15 of premium to offset the loss on the long dated LEAPs. Ten days later, the stock closed below its 200 DMA, another bearish sign! On November 11, the $50 calls we just sold traded for $0.40. Once again, we could roll our calls down, buying the $50 calls and selling the $49 calls (trading at $1.01), generating another $0.61 of premium. Overall, we would have sold $3.04 of premium against the $5.00 long call loss. Once again, not a perfect situation, but a much better result.
The scenario above is really one of the worst case scenario as ABT lost close to 10% of its value. This did create a larger loss in percentage in our position, but once again, with much lower capital at risk.
These 2 examples show what could go right and wrong with this type of trade – you will not get quick and big returns but you should also not expect large losses. Targeting 5-7% a month is a good goal and makes for big long term returns. Also, in these examples for simplicity I have used moving averages as triggers, but they are too lagging for precise trading. Other indicators are more reliable and produce better results.
