Wednesday, December 16, 2009

Thinking About the UNG Covered Call

My position on UNG, the natural gas etf, is about to expire after the end of trading on Friday. I hold shares of the stock with a base price of 9.12, and against those I sold calls with a strike price of 9 (-c9).

The UNG trade is a fine example of why covered calls are such wonderful trades, and why they always, somehow, create a feeling of unhappiness, like someone picked your pocket when you weren't looking.

(When the Buddha said, "Everything is unsatisfactory -- dukkha," I'll bet he was thinking of covered calls.)

Properly set up, with the price basis and strike price closely aligned, a covered call will always be safely profitable. And yet, there's always a sense of danger and loss. For if the share prices go up, the covered call soaks up profits that would otherwise go to the trader. If share prices go down, the trader can nervously comptemplate how close he or she sailed to the edge of disaster.

When I sell a call against shares of stock, I'm receiving money and in return assuming an obligation to sell those shares at the strike price, no matter what the price of the stock does.

UNG is now trading at 10.09, the strike price of the calls is 9.00, and my basis on the shares is 9.12. I sold the covered calls for 0.51, and that money is safely stashed in my pocket.

If I honor my obligation now (and I don't choose the timing, the person who bought my calls does), then I am giving up my stock for 9.00, an actual loss of 0.12 (9.12 - 9.00). Moreover, if I hadn't sold the covered call, then I could sell those shares of stock for a gain of 0.97 per share (10.09 - 9.12).

On the one hand, I have a profit of 0.51 less my 0.12 loss on the shares, or 0.39. On the other hand, I could've made 2-1/2 times that profit had I not sold the call.

So, was UNG a bad trade? I would argue not at all.

First off, my profit is 4.3 percent on a trade that lasted one month. That's 52 percent a year. I'll take that sort of return any time.

True, by doing the covered call, I lost out on 10.6 percent profit, or 127 percent annualized. But that analysis is Monday morning quarterbacking based on a 20/20 hindsight, with a crystal ball tossed into the bargain as well. Based on what I knew at the time, the covered call made perfect sense.

When I bought the stock on Nov. 17, the signals pointed toward a bull period, an increase in price. Instead, as sometimes happens, the stock turned south the next day and declined. Technical indicators don't always work.

I could have sold the stock for a loss, but I'm always reluctant to lose if I can find a winning alternative. So I sold the covered calls on Nov. 18, knowing that I would have a 0.39 profit no matter what the stock did.

The stock price remained below my 9.12 basis until Nov. 25, when it bumped up to  above 9.60 on a bull signal, and then on Dec. 1 dropped below my basis on a bear signal.

On Dec. 7 the price again rose above my basis on a bull signal, paused for two days, and then continued to rise, opening above near-term resistance on Dec. 11 (although closing below it).

Yesterday, Dec. 15, was the first day that the stock had an up day that was above near-term resistance.

The covered call made sense for most of the month. UNG hit a low on Dec. 3 of 8.50 after moving below near-term support. Had I not sold the covered call, I would have been looking to sell at that point for 0.62 loss. There was nothing to suggest that the stock price would turn up again.

I'm happy with the trade. It would have been better if the strike price had been at or slightly below my basis, so that I would have no loss or even a small profit on the shares themselves. But the overall position is profitable, and profit is why I do this.

There are many books on covered calls, which are a basic options strategy open to anyone, even inexperienced traders.

One of my favorites is Covered Calls and Naked Puts: Create Your Own Stock Options Money Tree, by Ronald Groenke.


Ronald Groenke's publisher has let us know that his "Money Tree" book on covered calls and naked puts is out of print. His latest is Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income 

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