Bookmark and Share Sep 1, 2010 Conservative Investor Or Aggressive Investor?

Conventional wisdom says covered calls are a conservative (and often boring) investment strategy. However, like most tools or techniques, it is possible to ratchet up the risk (and potential reward) on this one, too. Let's look at two different styles of covered call investors.

Meet Carl and Aaron

Carl the Conservative is a risk-averse investor. He is at or near retirement, has a large percent of his nest egg in bonds, and dabbles with writing calls against his large cap dividend-paying stocks that he's owned forever. He is targeting 1%/month return, but would be happy with 0.5%/month (6% annually) to supplement his dividend and interest income.

Aaron the Aggressive is a risk-loving investor. He has a portfolio margin account, trades many times per day, is not afraid of earnings release dates (after having done careful research), and seeks maximum portfolio return by any means. He is targeting 1%/week return, but does suffer occasional losing weeks.

Can each of these guys find value in the covered call technique? Absolutely. Let's take a look at the motivations and decisions each might make to achieve his goals.

Carl's world - the land of bonds

Carl worked hard for 40 years to save up his nest egg. He may not have set any records for annual rate of return, but slow and steady has gotten him to a comfortable retirement. Most of his money is in highly rated bonds. The only problem is that with today's interest rates he's only earning low single-digit rates of return.

Carl is willing to take on a bit more risk to earn a better return than bonds pay. He does have some assets in large cap dividend-paying equities but he doesn't want them called away because they are in a taxable account and he has a low cost basis.

Carl typically writes out-of-the-money calls that are 2-5 months from expiration. For example, in August when US Steel (X) is trading at $46.87 he writes an Oct 55 call for $1.19. There's an ex-div date before expiration so he'll get that 5 cent dividend, too. There are no earnings releases before Oct expiration.

Total return if flat is 2.6% in 75 days , or 12.8% annualized (just over his goal of 1%/month). If X rises more than 8.13 (17%) by Oct expiration then he'll buy back the options (potentially at a loss) to avoid a tax event on the underlying.

Carl doesn't trade on margin and doesn't watch his stocks every day. He has owned X for years and plans to keep it for years to come.

Aaron's world - the land of leverage

Aaron is in his peak earning years with a high paying job. He can withstand a significant trading loss and is willing to take on more risk in an effort to make his dream of early retirement become a reality.

Aaron loves leverage. With a diversified portfolio his broker gives him over 5x leverage in his portfolio margin account. With his $500K of capital he can buy $2.5M of stocks and write in-the-money calls against them. He likes the new weekly options because every Friday is an expiration Friday. He only has to be right for about 5 days on any of his covered call investments.

Aaron knows leverage cuts both ways so he tries to be "conservative" while using his 5x leverage. For example, on Tuesday of a given week he will buy 2000 shares of IWM (diversified ETF) at 66 and sell in-the-money calls that expire on Friday, with a strike of 63, for $3.30. Return if called is 0.48% in 4 days, or 43% annualized. Of course, the use of 5x margin means his return on actual cash is much higher. If IWM were to fall below 63 (a drop of 4.5%) in 4 days, he'll sell another set of calls the following week (and keep selling calls (with appropriate strike prices) until called).

High risk? Yes, because of the leverage employed. High reward? Potentially. His strategy is to do covered calls on a couple dozen stocks (including ETFs) for diversification. As for position size management, he will allocate no more than 5% of his $2.5M leveraged cash (so $125K) into any single position.

In order to achieve his goal of 1%/week (unleveraged) he needs 0.2%/week with 5x leverage (assuming margin interest rates remain low). That low threshold allows him to sell some very deep in-the-money calls.

Which is better?

Depends on your situation (age, net worth, sources of income, tolerance for risk, return goals, etc). If Aaron is right about direction he will make higher returns, but if there's any significant decline and he's unable to exit quickly enough he could face significant losses and/or margin calls that would make it difficult to recover. (Not to mention his blood pressure and stress level are probably higher than Carl's.)

Covered calls remain one of the most popular strategies available. They can be used in different ways by both conservative and aggressive investors.

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