Covered Call Options: Show Me the Money

Covered calls some days leave me cold. They take a lot of money to implement, compared to other strategies. They limit me to low priced stocks, which often are priced low for a reason. And they lack sex appeal. No one can ever pretend to be a Power Trader dealing in covered calls. What a pleasure it is, then, to crack open Ron Groenke's new book, Show Me the Money: Covered Calls and Naked Puts for a Monthly Cash Income, and have him remind me of why covered calls are such a neat way to trade. They make money month after month. And they aren't hard to do. Consistent earnings without lot of work? What's not to like about such easy money.

Mr. Groenke gets to the heart of what covered calls are all about on page 14:  "Think of it as picking money from a money tree like you would pick fruit from an orchard."  And in 200 pages he tells you how it's done. . . .



A covered call works like this. (My explanation, not Mr. Groenke's.) You buy shares of a stock. You then sell a call option on the same stock. By selling a call option, you assume the obligation to sell your shares at a certain price, the strike price of the option. In return for your taking on that obligation, whoever bought the call pays you some money, called the premium.

If the stock price rises above the strike price, then you sell your stock for the strike price, which is less than you could get on the open market. If the price stays below the call, then the call eventually expires worthless. You keep your stock and the premium from the call. And you can, if you like, sell another option against your shares.

An example from my holdings that I've been tracking in this market letter is my covered call on LVS, the Las Vegas Sands Corp., which owns casinos and hotels.

I bought the shares and sold the call on Dec. 16. The stock had been trending sideways for about three months.

The shares cost $15.77. And by selling the call with a strike price of $16, I immediately pocketed 94 cents in premium. (All the prices are per share, of course.)

It turned out to be quite a roller coaster ride. The shares dipped as low as $14.87 on New Year's Eve, and then soared after the New Year to a high of $19.12 after optimistic reports of gambling revenue in Macau on the China coast.

Had I just owned the shares, without selling the call, or if I had chosen another bullish directional strategy, I would have spent half of December with that churning sensation you get in your stomach when you know you're about to lose big. Had I chosen a bearish strategy, I would have spent half of January filled with dread.

Either way, whether I eventually profited or lost from the trade, I would have paid big with my health and happiness. As it is, I will make 32 cents on the stock ($16 strike price minus the $15.77 I paid). And I get to keep the 94 cents I got from selling the call. So $1.26 in profit (before fees) on a $15.77 stock, 8 percent profit in one month.

Mr. Groenke in Show Me the Money, as in his previous works, teaches the way Socrates did, through dialogs between a professor and his former pupil and family. It's a friendly and accessible approach that avoids the techno-jargon feel that mars so much writing on the markets.

Which is not to say that Show Me the Money avoids the technical. Far from it. It is filled with tables, charts and a few arithmetic formulas that give you the tools to understand covered calls and to make them part of the way you manage your money.

Chapter 6 is almost entirely taken over by an indispensable list that tells when you should sell calls at the money, in the money and out of the money. It helps keep the reader from being swamped by the overwhelming number of option choices.

In the book he teaches basic techniques of fundamental and technical analysis that are useful in choosing which stocks to trade and when to trade them. (Not just for covered calls but for any strategy.)

My approach differs from Mr. Groenke's in this regard. He looks at earnings and revenue, and I never do.

I don't do fundamental analysis because I consider it to be more suitable for a long-term strategy. When I deal in covered calls, they're associated with stocks that trade more than 5 million shares a day. By definition, they are household names, and if they're in trouble, that will show in falling share prices. And covered calls are a short-term strategy: In and out in a month.

Mr. Groenke has also written software that removes a lot of the drudgery from the search for covered calls. It is available as a separate product. Mr. Groenke in his book provides all the education you need to trade covered calls using his methods without the software. It's a convenience, not a necessity.

I came to Mr. Groenke's earlier works when I was first trying to understand options. And my very first options play was a covered call, with a book by Mr. Groenke open beside my keyboard, and it made money. So I count myself lucky to have run across his work early in the game.

At the outset I mentioned some things I don't like about covered calls. To play, you've got to own the stock in blocks of 100 shares. If you're like me, you tend to favor smaller positions that allow you to bring more diversity to your portfolio.

So, I set an upper limit of $2,000 for a single position, and I'm really much happier with $1,500. That means I find myself restricted to stocks that sell for $15 or $20. With the market collapse in 2008, stocks got real cheap and there are a lot of companies selling in that range. During the boom years, not so many.

By contrast, my typical all-options positions run about $500 on stocks costing up to $100 or so a share. I'm able to choose from a far larger universe for a third or a quarter the risk.

The other strategy that Mr. Groenke discusses, naked puts, also requires a lot of cash. When you sell a put option, you assume the obligation to buy shares of stock from the put option buyer at the strike price. If the stock price rises above the strike, then you can buy the shares at a lower price and then sell them at the market price for a nice profit. But you've got to have enough cash in your account to buy those shares, and so that necessity limits you to cheaper issues.

With the January options expiring, I'll be scanning for February covered call possibilities this weekend. Keep your eye on this market letter, www.timbovee.com, or on my Twitter alerts, twitter.com/TimBovee.