Last week in the
I discussed what I thought would be the "
Trade of the Decade
Admittedly my assumption, like anyone attempting to
prognosticate the future of the market, carries no guarantee. I
always know that my "guess" is no better than anyone else's
"guess." But that should never stop us, as self-directed
investors, from making an assumption and wrapping an options
strategy around it.
Within the article linked above, I discussed how I thought
bonds prices would take a nose dive over the course of the next
The global financial system is in dire straits. Debt burdens
are at epic proportions on every level - global, national, state
and local. Indeed, resuscitation looks doubtful.
In my view, one can't ignore the current failures that are the
direct result of the "prosperity boom" that began in the 1980s
and came on the backs of ever-expanding credit and debt. Advanced
economies are witnessing the damage of the flawed theory
But no matter what my thought is on bonds, I just want to use my
directional assumption as a potential lesson on how I use covered
What do you need to initiate the strategy?
One-hundred shares of stock and a liquid options market. By
liquid, I mean options that are more heavily traded and that have
narrow bid-ask spreads.
If you own at least 100 shares of stock, then you have the
ability to "sell a call" against your stock (assuming it has
options, which most do).
Remember, 100 shares of stock = 1 option contract.
When is the preferred time to implement the
In general, you want to sell covered calls when the implied
volatility of your underlying asset is higher than the historical
norm. That means that option premiums are generally rich, which
generates a higher-than-normal return on the proceeds of the
Now let's create the scenario.
You recently purchased 500 shares of
ProShares UltraShort 20+ Year Treasury
for $61.50 with no intention of selling the ETF anytime soon -
it's a long-term investment.
TBT has experienced a sharp pullback over the years, so
implied volatility - and thus, option premium - is higher than
As a result, you wish to take advantage of the increased
options prices by selling a few covered calls, thereby reducing
your long-term cost basis … which is the ultimate goal of a
covered-call options strategy.
Again, your average purchase price is $61.50. With an implied
volatility of approximately 26%, you can go out to the 67 strike,
have an 80.95% chance of success on the trade and bring in $73
per 100 shares.
What does that mean?
It means that every 50 days you are able to potentially
collect $365 against 500 shares of TBT. Annually that equates to
approximately $2,555 of income, but more importantly it lowers
the long-term cost basis to $56.39 a share, or 8.3%. Not bad.
The above scenario is a more conservative approach. Six
strikes out in TBT offers an 80% chance of success (i.e., the
option will expire out of the money, or worthless), so you should
expect that not every month will be successful. But that's okay.
Remember, you are going to own this stock for the long term. Any
reduction of your cost basis is a step in the right
However, some options professionals prefer to sell at around
the 68% success interval. If you sell two strikes lower at the 65
strike, you still have a 72.05% chance of success on the trade.
But more importantly, you can bring in $114 per 100 shares. Of
course, the probability of the call expiring out of the money is
lower. But if you are more confident in your assumption, you can
collect $570 against your 500 shares, or $3,990 over the course
of a year. This would lower your cost basis to $53.52.
Another way professionals use covered calls when taking on a
lower probability of success is to sell only three contracts
against their 500 shares. This allows them to stay longer than if
they sold against all of their shares. Again, it depends on your
assumptions at the time of the trade.
Try out various scenarios using the chart above. Take the
example and plug in other stocks. If you own stock for the long
haul, covered calls is
strategy. It doesn't cost you a thing, so why not bring in some
income while simultaneously lowering your cost basis.
I hope this helps a few of you in your long-term
And as always, please do not hesitate to email me with any
questions or comments at
Editor and Chief Options Strategist
The Strike Price