Screening Covered Call Options for my Traditional IRA

For the past couple years I have have mostly ignored my Traditional IRA.  I would put money into it every once in a while but it would mostly just purchase the only mutual fund that was in it The Fidelity Freedom 2050 (FFFHX).  I know that sunk costs shouldn’t matter but I promised myself if I ever got to even I would sell the whole thing and use the couple grand in there to try a trading idea I have had for a while.  I WANT CRITICISM PLEASE!

What is a Covered Call?

To understand what I am doing first you need to understand what a covered call is.  According to Investopedia a covered call is,

An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium

A covered call has no additional risk then just owning the stock in a normal manner.  I actually think it wouldn’t be a hard argument to make that it is less risky as you have actually received some of the money you invested back in cash.  This fits in perfectly with my income oriented sense of investing (and my risk tolerance of an 82 year widow).

In a covered call I own (at least) 100 shares of a company I then sell a contract (1 contract = 100 shares) that says if the company reaches $X price (the strike price) by a certain time the purchaser gets the option to purchase the shares at that price.  When they are buying the contract they believe that the share is going to be worth more than that amount.  For creating/selling this contract I get a sales price. 

How I am Going to Invest my Traditional IRA

My goal is to find companies with a market cap of at least $200 Million, a positive P/E, a stock price of below $5.00 per share and are traded on the options exchange.  From the remaining companies I will research them one by one to determine whether to move on any of the options available.  The covered calls will be out of the money options that will expire within 0 to 6 months of purchase.  The strike price will be an amount that I am very okay profit-wise.

Stock Screener Results

My first purchase is a fantastic example of what I am looking to do:

My First Purchase Using Out of the Money Short Term Covered Calls

I have utilized this technique in the past, but never involved my blog which keeps me accountable and has a built in feature of being able to record my moves.  Also since this purchase is one that I was involved in before I came up with the screening options it is falls a bit outside of the strict guidelines needed to figure out which stocks/options to even look at.   Even though I have done this before this is going to be my first “recorded” move:

  • Bought 575 Shares of Sprint at $2.25 on 2/22/2012 (I had a a few in the account to round me up already)
  • Sold 6 Sprint Covered Call Option Contracts on 2/27/2012 for a Strike Price of $3.00 in August

Sprint - Fidelity Purchase

I am not an investment or option guru by any means but here is my thought process on the available options:

  • Sprint Increases to $3.00+ in August – my shares are acquired at $3.00 for a very healthy 30% gain inside 6 months or so months! Plus my $111.89.
  • Sprint stays the same – I keep my $111.89 (which I will reinvest in another stock pick) and the shares remain mine.  The $111.89 is about 8.5% of my initial investment! So at risk is really only 92.5% of my initial investment.
  • Sprint goes down – I believe in the longevity of the company so this really isn’t a huge deal as I am willing to keep selling covered call until the 3rd largest national wireless provider gets their act together or is acquired.

Screening For my Next Purchase

Using the Criteria above my Stock Screener came up with 25 possibilities.  Right on the list, was Vonage (VG) which I am shocked to learn that it is trading at just 1.35 price to earnings and earned 1.72 per share.  There isn’t a lot of option activity so not sure I’ll be able to actually sell a covered call so I will watch it in the upcoming months.  But for his next purchase I am going with Radian Group (RDN).

  • Shares are trading at $3.50 per share
  • P/E Ratio of 1.57!
  • Activity on the option front

Thinking I can sell the May $4.00 Strike for .30 – .40 per contract so if I can get .30 I will get 7.5% off my purchase price back with an upside of 15%+.  Not bad for 2 months!  If it doesn’t get called then I just re-sell it for 2 months later again.

Some Final Thoughts

Why Use Stocks Below $5?

I don’t have a lot of money in the account, maybe a couple grand and so I need to be able to purchase enough multiples of 100 so that I can sell a few covered call option contracts to make the $8 fee not seem huge in comparison.

Why in my Traditional IRA?

I don’t have to keep records! The whole thing will be eventually taxable so I don’t have to keep tax records which I believe would be a PAIN in this type of strategy.

What am I missing with this strategy?

17 Responses to Screening Covered Call Options for my Traditional IRA

  1. I’ve done some covered call investing and you seem to have thought it through quite a bit. Overall, if you’re comfortable with the risk it’s a decent way to get a little extra yield or a “sell strategy” for getting an extra percent or so by selling deep in the money calls with a short expiration date. (Although I’m pretty much an index fund guy now)

    I’d just caution to also look at whether there are any big catalysts during the option term. I once thought I had a no brainer but didn’t check company events. It was a long time a go and I was really dumb, but I missed a pending regulatory approval process that didn’t go well… stock tanked. I got my premium but lost way more than that. So I’d also check what’s going on w/ the companies during the option term to see whether there’s more risk than meets the eye.

    Hope this helps.

    • Interesting point! I did not consider that AT ALL since I was so used to purchasing stocks for the long term (i.e. ignoring noise like that)

  2. Oh so this is the post. ;)

    I’ve never been much for covered calls. Frankly, I don’t really understand the idea of buying a stock and then betting (essentially) that it won’t go up by writing calls for income.

    You get fat premiums on a stock like Sprint for a good reason; high operating leverage means this puppy could fly on a good quarter, or a long-term improvement to the underlying business.

    If you can grab yield of 8.5% every 6 months without giving up your shares at below market price, then you have done very well. Ultimately, though, I get the sense that covered call sellers end up getting the short end of the stick if they actually believe in the company. I’ve sold covered calls a couple times – something that I got into mostly for fun – but I can’t see myself making it part of my actual investing strategy. I just don’t see a reason to limit my upside for a small annual yield.

    • But how many companies actually grow their share price by 10%+ Per year? If I am selling the contracts above that 10 or even 20% it might be about time to get out anyway.

      • Why would you want to own a company that couldn’t?

        Fundamentally, what’s the point of buying a company and then betting it won’t go up?

  3. JT brings up another good point. Most people I’ve spoken with about covered calls “used to” use them and now use them every once in a while but not regularly. I’m not much of a “it must not be a good plan or else everyone would do it” guy generally, but I think it does say something about whether it’s a viable long-term strategy.

    That being said, a couple of grand isn’t going to kill you.

    • I am going to say that a lot of people don’t use them because they must be a HUGE pain in the ass come tax time. Think about if I keep selling these things for the next 9 months! Wow. The paperwork isn’t worth the gain lol, but I am doing it all in my IRA so I can basically ignore that aspect.

  4. I use them, and as long as you are comfortable with giving up some of the upside and/or giving up the shares, I think they’re fine.

    I’m doing the same thing right now with BAC, but I’m losing $1 per share right now because it’s run up so far. So, I still get the option $, and I still get a nice return on BAC, but I could have had more if I had just taken more risk.

    • I think RIGHT there seems to be the downside of covered calls…that “I should have had more balls” attitude! Like when you have Trip Aces but there is a possible flush on the board and you are worried about it.

      I think that is why a lot of people stop using them. They get burned once and forget how much they made but remember how much they DIDN’T make.

  5. When selling covered calls, it is crucial that you have an exit strategy in place before you execute the transaction. A few years ago, I was doing rather well with this strategy until I had a few positions go south rather quickly.

    When all was said and done, I had a few hundred shares of stock that were worth half my cost basis.

    • Hmmm like a protective put? What is that called when you play them off each other? A straddle, maybe? I am very new to the Options world.

  6. Well, keeping them in the tax free account is definitely a good idea. Beware of low priced stocks since there is usually a reason for it. You still don’t want to lose 90% of an investment when a company goes bankrupt.

    • You are 100% correct. That is the reason I chose a minimum of a $100mil market cap, I know that is TINY but my thought process is that if they have options contracts being sold it has some stability. Not sure if my logic is sound though.

  7. Selling covered calls is not as easy as it seems. Yes, you do earn a very good guaranteed premium, but you assume new volatility risk. You have a limited upside and large downside. If the call expires with the stock down heavily, your loss is locked in. If you continue to sell covered calls, the premium you receive will decrease proportionate to your loss. Also, if the stock rebounds, you will miss out on most of the recovery. In total, you must make several positive trades to pay for each losing trade, since they will be so much larger. Finally, I would recommend against investing in super-cheap stocks. The spread on options is much greater than the spread on stocks; a 1 cent spread on the underlying could come along with a 15 cent spread on the options. The loss to the spread will dwarf your $8 commission if you don’t fill at parity. For example, AMRN is $8/share with an option spread ATM of .15, while GOOG is $608 and has a spread of .20. Through poor order construction, you could easily start your trade $100 below parity.

    So in summary, I recommend not selling calls on stocks that may fall, even if they are likely to spring back, and buying the most expensive stock you can afford. I’ve had great luck selling covered calls so far; hopefully you will as well.

    • Alan,

      I really appreciate the thoughtful response. But since I am new to actually using the strategy (vs. researching it) I have a few questions in response to your comment.

      1) Why do I have a large downside risk? Lets say I bought the stock without the covered call, wouldn’t I have the same downside risk? I am not buying stocks without researching the fundamentals (per the stock screener).

      I understand the part about the falling strike price and recovery. That makes a lot of sense. It is almost like I have to keep the same strike price and just take less money each time (if there is bid/ask action of course). Correct?

      2) Don’t I avoid the parity issue if I am doing Limit orders? Or am I misunderstanding your point?

      3) In your summary it says you like covered calls just on more expensive (in terms of stock price not value) stocks…but isn’t that downside risk point, the one I didn’t understand still present?

  8. There are two ways to compare covered calls: versus long stock and versus cash. If you compare versus buying stock, you have a slightly better downside risk and a much worse upside potential. If you compare versus cash(or your account value before the trade), you have a large downside risk and small upside potential. It is easy to say, “I don’t need big upside potential, just my 8% a month is plenty, and if the stock goes down, I would have lost more by going long anyway.” This is an invalid mix of the two accounting methods. You will indeed miss that upside potential, because 8% a month isn’t enough to make up for -50% every six months, especially if you reinvest your profits.

    And yes, you can avoid locking in your losses by keeping your strike price the same, although the premium will decrease dramatically. Option B is to sell calls ATM with the new price, but you will still get less because options premiums are proportional to the stock price. Keep in mind that option A is not a TRUE investing strategy because it is not time-specific; you are basically saying “I’ll make money by waiting until the stock goes up.” Not saying it’s a bad idea, just that it isn’t foolproof.

    Your execution price can be improved using limit orders, but it depends on the exact trade. At my broker, options spreads are traded as a unit, meaning that someone has to take the opposite sides of ALL the legs together. Since deep ITM or OTM options barely trade in the first place, the market for your spread can get extremely thin. And also at my broker, spreads are not guaranteed national best price like stocks are. Finally, if you set a limit price, and the stock moves strongly against you, your limit price will no longer be a good deal; the varying delta of options means that a limit price is only fair for a certain price of the underlying (although I’m still researching that). You can definitely improve your execution, but it takes careful planning. At the very least, you can avoid trading OUTSIDE the spread, which is what happened to me using market orders.

  9. Great job! I too wrote some contracts on Sprint. I think that is a good call. However, you can get a little bit better return by writing month-to-month. (I just wrote my contracts on the April 21 calls)

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