Our possible strategies for using call options

January 17th, 2009 · No Comments

Yesterday I talked a little bit about the basics of trading covered calls.   Today I want to record some of what we’re thinking of doing in terms of the strategy for our covered call trading.  Please keep in mind that this is still just a plan and it may not survive first contact with reality.

image: http://www.sxc.hu/profile/lockstockb

image: http://www.sxc.hu/profile/lockstockb

The general plan is to buy stocks of large-cap, globally active, dividend paying companies and then sell covered calls to lower our cost basis while collecting dividends along the way.  We’ll only sell calls for strike prices that lock-in a reasonable gain, say something like a minimum of 10% in 6 months.  That would be a 21% APY and I’d be happy to earn that on the bulk of the portfolio.  Though I’d prefer to keep the term even shorter than that while keeping the APY the same.   We will have to balance the term against the options price to ensure that trading commissions don’t eat too much of that away.

[EDIT:  A writeup of a strategy very similar to what I describe above is available here.]

Initially for us, it will probably be difficult to find situations where we can earn a significant amount over the trading commissions because the portfolio we’re using isn’t large enough to buy several hundred shares at a time of anything that (a) we’d really want to get caught holding on to for a long period of time if the sold options aren’t exercised, and (b) has a good volume of options trades (in case we want to close out the position prior to expiration), and (c) has options that trade at more than 50 cents (which would be $50 for one option and thus not alot over comissions we’d currently have to pay.)  For example, my order yesterday was for just one option and was mostly to try the process out.   Actually we’ve recently been discussing budget changes that may allow us to contribute much more than our minimum $100/month to our GI portfolio, so perhaps this point will become moot in the near future?  Both because the portfolio will be larger and thus we’ll be able to use larger number of shares, but also because we could switch to a broker like Zecco that has lower comissions.

An alternative to that strategy might be to pick something with significant price swings (i.e. volatility) and just set a strike price that locks in a moderate short-term return while collecting the premium for selling the call option.  I’ll admit I haven’t done much research on this type of strategy but I do think we’d be looking to make the bulk of the profit off the selling of 1-month out options and really not require too much of a price rise in the underlying stock or ETF.  It seems to me that the risk here would be in not getting the option exercised, and getting caught holding something for the long term that you don’t really believe in for that time period.  The attractiveness here is that the small profits compound.  For example, if you can buy a stock at $50 and sell enough options at $0.75 that the commission cost is negligible then you’ve made a 1.5% return in a month, which means a 19.6% APY when you repeat that over a year.  If instead we could sell the options at $5 by extending the expiration out to 3 months, then we’d be making 10% every quarter, or a 46.4% APY.   We’d need some software to scan option prices and underlying securities if we’re going to try that though.  It will need to identify situations where the options trade at that high of a percentage of the underlying equities value.

Yet another alternative is to skip making these plays in our new GI portfolio and instead make them in our much larger, traditional, retirement portfolio.  We’ve recently discovered that Fidelity will allow us to trade options in our rollover / traditional IRAs (which we didn’t know was a possibility for that type of account) so we’re considering making some conservative covered calls there.  I say we want to make conservative plays because most of the investments in those accounts are things we really believe in for long term (multi-year) periods and we wouldn’t be too excited to have to exit those positions if we weren’t getting significant income from the sale of the calls.  Especially if they’re not exhibiting decent volatility where we felt we could get back in on a new price dip.   Perhaps we should just designate these portfolios as investments instead of using them for options trading?  Or wait until we get more options experience and can better recognize how to make more effective option trades?  I dunno yet.  It is clear we have more money and thus more possibilities here than in the GI portfolio.  Decisions need to be made.

More on this topic (What's this?) Read more on Call option at Wikinvest

Tags: Options

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