Ask Mike:
Why not just buy the stock without the call if you're going to try to get out early?

Question:

Hi Mike,

I've been giving your new covered call enhancements some thought and have a question.

If you really are going after high quality stocks with strong positive indicators, ... and thinking of getting out of a CC trade in 1-3 weeks when the stock price rises, why even have the Call? Why not just buy the stock.

Those indicators you mention are the same ones used for good stock picks.

My point is: When the stock goes up, so does the option (but not always dollar for dollar, but generally per the delta). So in one of your recent trades, in order to get out of the trade, we had to buy back the call at a higher price than we paid which detracts from the potential higher gain of just owning the stock alone.

I might be missing something here but thought I'd ask.

Ken R from Las Vegas

Mike's Response:

Hi Ken,

Here is what is important to keep in mind... At the end of the day, our objective is to make as high a return as we can for the lowest risk.

When I put on a covered call, generally, 50% or more of my expected profit is made from the sale of the call. The only reason that I would make the trade in the first place is that I am satisfied with the return for the risk that I am taking.

However, if I can improve my position by either making a higher return or decreasing my risk on the trade, then it behooves me to take advantage of any such opportunity.

When a covered call is placed, I know at the time of the trade, what my annualized return would be if the stock moves at or above the Strike Price and the stock is not called away until Expiration. This is a simple calculation where I take the number of days between the date the trade is originated and the date of Expiration and the total net return expected at Expiration. Then, I extrapolate this rate of return for a full year.

Here's an example: Let's say my estimated return for a covered call trade is 10% if the call is exercised on the date of Expiration. Let's say the duration of the time between when the trade was placed and the Expiration date is 2 months.

The net return is 10% and the annualized return is 60%. This is based on the assumption that if I can make 10% every 2 months, in the course of a year I will have made a total of 60%.

Now, let's assume that 1 month after initiating the trade, I can get out of the trade by buying back the call and selling the stock and make 8% net on the trade. 8% is far less than 10% in fact it is 20% less than 10%. So, why would I want to make such a trade?

Here is why... If I can make 8% in one month, then my annual return would be 96%, which is more than 50% better than if I had kept the trade on through the date of Expiration. Further... and this is a very important aspect of this strategy... In getting out 1 month early in a 2 month trade, I removed 50% of my risk. I took a month's risk out of the equation risk that the stock might move against me.

So, with getting out early, based on an evaluation of the annualized return, in this example, I was able to increase my annual return by more than 50% and reduce my risk by 50%. Getting out early also lets me put my money back to work in more trades. This, of course, is a very good deal.

Therefore, each time I put on a covered call trade, I immediately begin looking for an early exit, where I can increase my annualized return and lower my risk.

Thanks for the question, Ken.

Regards,

Mike