Marty,
But...in theory...if we can squeeze out 3-5% returns per month we can afford to handle some major declines. I will probably buy 4 to 6 stocks, looking for solid companies that are bottoming out and write one month out (front month?) covered calls trying to average 5%. Obviously if you can hit 50% a year, you are in tall cotton. But I can see how losses in the underlying positions can really cut into this.
Losses in the underlying can do a lot more than just "cut into" your potential 50% profits. Targeting solid companies that are bottoming is certainly prudent, but assuming 3-5% monthly returns will protect you against a "major decline" is expecting too much. Suppose you sold a 5% front month ATM call, and the stock declines 5% that month. You still own the stock and have lost nothing. That's great- the short call gave you the protection you were looking for. But what if the stock drops 15% or 20% in that month? You are now in the hole by 10-15%. You think it wont go much lower since it pulled back so far, and after all you can collect those 5% premiums over the next few months and get well. "But wait" as they say in those infomercials. Where are you going to find another 5% premium? You will find it at a strike price that is below the net cost of your stock, including the two 5% premiums you collected, ensuring that if you are called out you will have lost money. If you were right in the first place, and this stock runs back above your entry price, you will not participate in the profits. To make sure you will not be called out at a loss, you can't sell the 5% premium; you will have to settle for the small premium at a strike at or above your net cost. That is likely to give you 1% or less, you are still under water, and you are fully exposed to the risk of a further decline.
I'm not suggesting there are no good opportunities for CCs, but I would not count on front month calls to protect me against the potential continued decline in this market. I have stated before that I would favor looking farther out in time for larger premiums for any covered calls in this market. While this reduces profit potential of the overall position, it increases downside protection. Other protection measures should also be considered, even if it is as simple as stopping out of a CC on a stock that takes an unexpected drop below your net cost.
Dan |
