Dwayanu, and thread:
I have worked up some examples, and have found what I consider a fatal flaw with an (over)simplistic strategy of using CCs as income. A fatal flaw, that is, unless one is willing and able to spend what might turn out to be a lot of time timing the market and repairing mistakes, which sort of negates the low-stress philosophy that has been discussed on this thread. I hope that V, and those of you experienced with this approach can either tell me what I am not seeing, or can confirm that this is a problem -- and how to fix it.
The over-simplistic approach is to do a buy-sell every month on a stock of your choice, live off the income, and go fishing, sailing, or whatever in between. Let's assume that one picks a good stock, one with enough volatility to pay good premiums, and does not crash, but just stays at the same level on average. I realize that if the stock goes up over the long term, the CC strategy would work, but so would almost everything else.
The problem is that during months when the stock goes down, one's equity has decreased, and one gets smaller premiums (though the same %). But that is not the fatal flaw, since one is at least somewhat protected on the way down. The fatal flaw is that during months when the stock goes up, one gets called and the gains are capped. So there is a cap on upward moves, but no cap on downward moves. Over the long run, this is a sure way to lose all of one's money.
Here is an example. Take a stock selling in August at 100, and say one buys 100 shares for $10k and sells a September 100 call for $5 (ignore taxes and commissions, just to keep the math simple).
At the beginning of September, one's portfolio value is $10,500 ($100k for the stock, $500 cash from the option).
You turn off the computer, and at the end of September, you return to find the stock at $110, and you have been called. Your portfolio value is still $10,500, a 5% return for the month and a rate of 60% for the year, not a problem at all. So you do this again. Except now you need $11,000 to buy the stock, and get $550 for the call (assume the same %).
End of Sept portfolio value = $10,500
Cash from the Oct 110 call = $550
Additional funds needed to buy stock = -$500
New portfolio value = $10,550
Now, let's say that at the end of October the price is $90, so your portolio value is down to $9,000. Trying to keep things simple, and sticking to your strategy, you buy 100 shares, and sell a November call for $450. Portolio value is now $9450.
At the end of November, the price is back up to $100. You have been called again, and your portfolio value is still $9450.
So in three months, on a stock that went nowhere, you have lost $550 (5.5%) with covered calls. Holding uncovered stock you would at least have broken even. Continue this process for a year and you lose over 20% on a stock that ends the year at the same level as it started.
Now, I assume the way to fix this is to have rolled up and out when the price went up, or to buy back and resell when the price went down. But now I am back to watching the screen and timing, and if I am going to do that, I'm back in the casino and I may as well trade.
Am I missing something? Maybe this is why McMillan says that CCs are used when one is slightly bullish, or at worse neutral on the stock. Although one can't be too neutral, or too passive. |
