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Author: SemperAugustus Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11006  
Subject: Re: Covered Calls Date: 7/28/2000 1:57 PM
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Do the math

Okay Ray,

I did the math about 9 months ago, and was plenty happy with my results. I had an annualized return of 24.8% from writing 17 CC positions (http://boards.fool.com/Message.asp?id=1380046000102008&sort=postdate). But I got sick of all the CC-bashing on this board, especially by you. I thought you were being arrogant and bullheaded. So I stopped dropping by, but kept on doing what I was doing.

So, it's time for another update. Over a two-year period, I've now held 50 CC positions averaging just over $6k apiece (range 1-22). I've been successful (= profitable) on 44 of those positions, or 88% of the time. When I've been successful, I've earned 19.6% in absolute terms, or 38.3% in annualized terms (average holding period has been 215 days). I realize that's nothing compared to what I could have got by buying Nortel or JDSU, but these were all good safe value stocks with dividends and rational PE's.

What about the other 6, you ask? Well, four of my “losers” lost 7-13%. No problem with that—just part of the game. But the other two lost 72 and 80%. OUCH!!! When people say you can't bail out quickly from a losing CC-position, they mean it. Net return on my 6 losers was –45.6%.

Put the winners and the losers together, and I've got a 5.2% average return, or 9.5% if annualized. A bit better than government bonds, certainly, but not exactly what I had in mind. Ignoring the two catastrophic losers, my average return would have been 13.4% (25.5% annualized), which just happens to be my target when writing calls (15 and 25%).

So, it took me 50 positions to discover what's wrong with writing covered calls. Rare events are what's wrong. To the vendor selling air-travel insurance at the airport, every $5 earned in premium writing looks like free and easy money, ripe for the plucking. Until you look up from your kiosk and see a Concorde slamming into a hotel. Then you say “$%&@ me.” So, my advice to anyone adamant about doing covered calls would be, keep an eye on your jets. And if one looks like it might be going down (i.e., a 20% drop), eat the spread, eat the commission, close the position, and bail out. Don't think about it; don't second-guess yourself; just do it.

But my best advice would be “just buy the stock”. If I'd just bought the stock and not sold calls, my annualized return would have been 20.3%, even with those 2 pathetic losers. If I had entered 25% stop-losses on all my positions, I would have had a 28.8% annualized return. I would have paid $530 in commissions instead of $2,495. My average holding period would be 420+ days and counting (with deferred taxes and favorable capital gains treatment if and when I sold), instead of 215 days and full tax rates.

I'm still doing a couple of covered call positions, but I no longer think they're a panacea. If I really want to buy a stock, but I'm not quite happy with the price, I might use one or two consecutive CC to lower my cost base, but if I still own it after that, I intend to leave it alone. Or, if I'm occasionally tempted to sell something that's had a big run-up, I might use CC to defer the sale. But I think most of the time I'd much prefer a trailing stop.

Sorry, Ray. You were right. I just didn't want to listen to you. Guess that makes me the arrogant and bull-headed one.

Semper
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