Ask Mike:
Are you getting too aggressive on your covered call exits?

Question:

Mike,

We talked many months back about the Stock/Options portfolio and how I felt we should sell the stock/cover the call when there is not much gain left in the play but there still is risk.

I feel maybe we have gone a bit too far? I know you are doing very well in this portfolio but as an example with RIMM, the stock is trading at 100 and the October 95 call around 9.80. This call still has about 4.80 in premium left in it. Since we are less than one month from expiration this is when the call will rapidly lose value as it comes to parity with the stock price.

Since we are short the call even if the stock went to say 110, the call at expiration would be worth only 15, so the stock goes up $10 and the call only 5.20. So we net gain more this way with lower downside risk.

This works best during the last month when premiums dry up quickly.

Something to think about as I often won't sell at your point and may wait out a few more weeks if the market is doing well.

On another note, if the trade is called to be covered on a Friday, I often will wait till Monday as you get a couple of extra days over the weekend to make a few extra $$ as the time element of the call shrinks and the stock usually won't change much.

I am sure you are aware of all of this but just thought I might discuss it with you.

Thanks,

Bret

Mike's Response:

Hi Bret,

All good and accurate points.

However, you don't touch on what I think are the most important elements of my current strategy: Liquidity of my portfolio and low risk.

Only time will tell if my strategy makes sense (meaning, if it consistently makes 30% per year, which is my goal).

Here is my defense of my strategy:

1) Let's take RIMM as an example... I've made 4% in a little less than a week. I am now free to reinvest that money immediately. One of the biggest knocks against a covered call strategy is that your money is tied up for a long time. In my methodology, my money is generally tied up for no more than about 2 weeks. If I can take the same money and use it to make 4%, 2 or 3 times in the same time as one would normally hold a covered call through expiration, I have the opportunity to make 8% to 12% in the same time and at far, far less risk.

2) Risk is a big issue. Virtually all of my profit in the Stock and Option portfolio is net cash profit... very little unrealized gains. If you look at my other 3 portfolios, there can be (and currently is) a LOT of paper profit. Paper profit is money that can evaporate in seconds. Almost all of my profit in the Stock and Option portfolio is consistently in the bank. So, the portfolio with the biggest annual rate of return also has the least amount of paper profit at risk.

3) Since I have gone to my '4% and out' strategy, I have had very few losing trades. Prior to this strategy, I was averaging 3 winning trades for every 2 losing trades. Granted, this strategy is less than a year old, but we have gone through some wild markets over the past 10 months and have done very well.

4) Another point on risk... Just as you suggested several months ago... why tempt fate for a miniscule potential increase in profit. The way I look at it, closing out RIMM today means I can get into another trade that only has to work in my favor for a week or so for me to make another 4%. This is a very small risk to take to double my profit; meaning, using the same money to make 8% at very low risk as opposed to making 8% at very high risk by holding onto the RIMM trade as you suggest.

Finally, it all comes down to total net gain for the year and the total risk that was required to get that reward. In my strategy, I have exceedingly low risk and well on my way to making at least 20% for the year... with a shot at getting us to 30%.

I would rather nibble away at 4% every week or so than to try to get 10% every two months or so.

Thank you for your comments and wisdom. Your input and insight are very much appreciated!

Best,

Mike