Before You Dump $50,000 Into This Options Strategy… Read THIS

Karim Rahemtulla By Karim Rahemtulla, Options Strategist, The Oxford Club

Alternative Income

Covered call trading is considered the safest of all options strategies. But who is it really safe for?

The truth is that it’s really, really safe… for your broker.

For investors, the strategy is “kinda” safe. You can still lose money – a lot of it – despite the usual examples of how the trade is “supposed” to work.

The covered call strategy, when applied traditionally – like the Cisco Systems Inc. (Nasdaq: CSCO) example I gave you last week – opens you up to the exact same risk that you would have if you owned a stock long. The only difference is that you would have taken in some coin by selling the call option.

For example, assume that you bought Cisco for $32. If it fell to $16, you would lose 50%. Simple enough.

Now, let’s say you bought Cisco for $32, and you sold a $35 call option against your position and received $0.50. In that case, your cost is now $31.50.

It did nothing to eliminate any more risk than that $0.50. If Cisco fell to $16, your loss would be close to 50% anyway.

In fact, a covered call could be even more dangerous.

Let’s take a pharmaceutical stock for example. We’ll call it XYZ.

On Monday, XYZ is trading for $27. It has a few drugs on the market, a decent pipeline, and it pays a nice dividend. It’s been around for a couple of decades, and institutions love it. Heck, even insiders have been buying the shares. Seems like a perfect candidate for a covered call trade to bump up that dividend a little.

You want to use a covered call strategy. So you buy the shares on Monday for $27, sell the $30 call option and pick up $0.50. Your cost is now $26.50.

Another investor makes the same purchase but does not sell the call option.

On Wednesday morning at 8:30, the company announces that one of its drugs is linked to an increased fatality rate amongst those 50 and older. It is the company’s best-selling product, and the FDA has advised it to pull the drug until further tests are conducted. Shares begin to tank.

At 8:35, the shares are at $20, down $7. The other investor enters a sell order and gets out at 8:36 for $20 with a $7 loss.

But you are out of luck… You cannot sell your shares until the options market opens at 9:30, and you have to wait until options begin trading because there is such a rush for the exits. At this point, shares are at $16. You sell and are down $11 minus the $0.45 – the amount you received after buying back the option for a nickel.

And you’re tying up a lot of money…

Last week, I promised to touch upon how much money you need to use a covered call strategy. Now, this applies to a trading strategy, not to selling calls against already existing positions that you plan on holding on to for a long time to come.

Think about the Cisco example… It was going to return about $0.50 on $31.50 at risk. That’s about a 3% annualized return. You can get 4% from a closed-end muni fund.

The upside is that if Cisco shares move up to the $35 strike and you collect the dividends, that’s a double-digit return. But it comes with a lot of “ifs.”

More realistically, you can generate between 6% to 8% from a covered call portfolio if the market does not crash and you aren’t chasing high-volatility stocks. So you will earn less than the market, but you’re taking less risk by receiving call premiums.

In terms of mechanics, you must buy at least 100 shares of stock before you can sell a single options contract. Most companies trade between $30 and $70. So you are tying up $3,000 to $7,000 in each position. Since not all trades will expire simultaneously, you can roll out of positions every few months.

You’ll probably be holding between five and 10 positions at any given time (most investors hold between 15 and 20 positions in their portfolio). When you do the math, you will need around $50,000 to get going.

That’s a big chunk of change. That’s why it’s critical to know the ins and outs of your options trading strategy before you take the plunge.

As I mentioned last week, there is another way to mitigate a lot of this risk by using a strategy that I put into use about 15 years ago. I’ll discuss that one next week.

Good investing,