Tuesday, January 29, 2008

An alternative strategy to covered calls

Instead of selling covered calls, I actually am considering selling put options on stocks for some extra income, which could work in some situations. First, when you are selling a naked put you are obligated to buy the stock from the put buyer, who has the right, but not the obligation to sell it to you at a predetermined strike price. If you invest a certain amount of funds each month into stocks for example, you are basically always buying at the market price. If you always invest 120-125 dollars per month in DIA you are trying to buy one share per month at a time, rather than all 12 at once, by using the power of dollar cost averaging. In this situation, if you sell a naked put on DIA at an in the money strike of say 122, you would be paid $3.10 for the obligation to buy DIA at $122. If DIA does fall below 122 at expiration, you most probably would have to buy it at the strike price. With this strategy you bring your cost basis significantly below the current market price of 122.19 to an actual $118.90 if your option is exercised. Since stocks have historically always been in a bull market over the past 200 years, it makes sense to me to buy stocks that have shown some weakness, get dividend payments and live the good life.
The shortfall in this strategy is that you are only buying stocks which are showing weakness. In a strong market you will miss on potential gains, because you are only buying a stock that has fallen below your strike price and thus there’s no guarantee that that you will receive the lower cost basis. In weak markets you will be able to buy your stock at a lower price, but you will see your stock dive further down. Thus you might have been better off postponing your buy.

Relevant Articles:

- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates
- Covered Call Options Strategy for cutting losses

1 comment:

  1. I agree with your general reservation about writing covered calls. Covered calls are great when a stock goes nowhere, but it doesn't protect you against big drops in the stock, and it forces you surrender too much capital appreciation if the stock makes a big move higher.

    But writing covered calls below the original cost basis of your stock can easily backfire if the stock makes a strong rebound, and you're forced to sell at a much lower price than the current market price.

    Most covered call writers trade exclusively for the income potential - stock ownership is incidental. But I advocate covered call writing for long term (dividend) investors as well.

    The idea is to scale things back and write covered calls from a much more conservative perspective. I call it the 1/3 Covered Call strategy - you simply write out of the money calls on only a portion of your holdings.

    This still produces income and it gives you far greater flexibility in case the stock moves significantly higher and you need to roll the calls out and up and not have to worry about being forced to sell your long term holdings.

    If you squeeze out even an extra 5% a year with this strategy, the long term effects will be profound.

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