$$ Buying Stock Too Early: Covered Call Strategy for the Impatient $XLF
I’m looking at this chart and think there’s a pretty good chance the stock will drop to $15 within 2-4 months.
It also sorta looks like an inverse Head-and-Shoulders (bullish) pattern? but I’m not entirely sure.
I want to buy the stock today! What if I buy it and the price drops? Based on this dividend capture strategy I came up with a solution that will work for me.
Here’s how it would look at today’s prices: I buy 200 shares at $16.65, sell 2x $15 June 2011 calls at $2.10.
- If the stock drops as I anticipate, I’ll buy the call back for less. For obvious reasons, can’t predict the profit at this point;
- If it doesn’t drop, and gets called away, I still make a profit of 1.8% net.
The plan is to hold XLF and write calls. Rinse-repeat.
So, in summary – if you can’t wait, buy early, then sell a deep in the money call, but not too deep so that you lose money if the stock is called away.
Calculation done using this covered calls calculator.
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Kat,
Viable strategy, certainly, but, if you are going for the XLF dividend of $0.056/month or $0.67/year, transacting on a monthly basis, two trades, is it still viable?
I had a quick look at your figures, but wasn’t sure if that $11.95 included the stock transactions in addition. You have a total of 4 trades per dividend collected.
What if when you sell your Options, IV is very low, and when you buy them back, IV has risen, as it might due to the whole expectation around the ex-date, can you still make money when the stock falls and the Option IV rises?
IV is currently @ 22, which is pretty low historically. Because your Option is DITM, there is a real chance that a fall to $15 [your postulated scenario] that IV jumps higher as the Option goes ATM
Also, over short time frames the Bid/Ask spread on setting up the Option trade can be a factor, although in a liquid Option like XLF, I doubt that this will be much of an issue.
I’ll check back and see how the trade goes, let me know!
Incidentally, how about MO, it has a $1.56 dividend.
jog on
duc
Duc,
the point of this trade isn’t dividend capture. That strategy merely gave me an idea how to buy into a stock faster. I just want to keep writing calls. Should be able to do it at least 3-5 times a year.
My calculators include all commissions, so the numbers above are net.
There’s nothing to prevent me from making money, no matter what happens to the IV. If the stock is called away, that should be the worst case scenario, as long as I’m patient enough.
I’ll definitely post updates!
Oh and in the future, I won’t try to guess the price direction, will simply write slightly OTM calls.
Kat,
Ok, if the point of the strategy is not dividend capture, then, it sounds like you want to gamma scalp, which is a good strat, but very IV dependent.
Selling Calls, that are 1:1 ratio, and DITM, [dependent again on delta] may well essentially do nothing: viz. a perfect hedge, which then gives you the dividend capture.
If your delta is wrong, you might end up losing money. Selling OTM Calls isn’t as risk free as it is generally advertised, in fact, it’s pretty damn risky!
jog on
duc
How will I end up losing money in the above scenario? What am I missing?
What is the risk in selling an OTM call other than” the stock can drop very fast and I’ll be stuck with it?
If I were just interested in holding the stock for future growth, I think it would make more sense to hedge via puts. I, however, just want to make some cash. It’s like my version of a rental property.
Kat,
Selling covered calls, is exactly the same as selling naked Puts. You would agree that selling a naked Put is very risky? If so, then, selling covered calls is highly risky. They are an equivalent position.
jog on
duc
Duc,
I don’t think either naked puts or covered calls are Very Risky. Unless you absolutely hate the stock you will be potentially stuck with, it’s not an extreme risk, like let’s say naked calls are. You wouldn’t do it with a penny stock that can go to $0 anyway, so…
In both these cases, the risk is limited to a fixed amount that’s known upfront. To me that’s not very risky 🙂
And aren’t naked puts a good way to accumulate stock for less?
Kat,
A naked Put is a good way to buy a value stock, Buffett apparently uses this strategy frequently, it reduces your initial cost. But of course you don’t have a naked put, just an equivalent position as far as risk is concerned.
The risk is that the stock goes to $0.00. An ETF is less likely to drop to $0.00, but can still generate a deep drawdown. Assuming you are willing to hold for a long holding period, and the banks recover, then, it should work out on a stock basis.
However, selling ITM, or OTM Options on this stock has a couple of other hidden risks. If the stock drops, then selling OTM options on your stock above purchase price brings in less premium the lower the stock goes.
Selling ATM, if the stock has dropped runs the risk of selling below cost, and locking in a loss. DITM Options have less TV, and thus again, reduce the profitability.
jog on
duc
Kat,
Bear Stearns was what, $280 at it’s top, it went to zero. Banks are hideously leveraged, and are always essentially bankrupt. An ETF of banks reduces the risk, but banks…
jog on
duc
Right, I understand the risks.
Sounds like you have a ‘bone to pick’ with XLF specifically, not the strategy itself.
Is there a sector that you like these days? Commodities? Gold?
Kat,
No, I’m indifferent to XLF, it’s the strategy that I don’t care for.
jog on
duc
As I said, a naked Put strategy is [to me] high risk. This strategy is the same.
jog on
duc
Kat,
As to a sector, anything pretty much will be bullish: Ag, Oil, Equities, you name it, inflation from the Fed drives everyone away from cash.
jog on
duc
Ok, you don’t like the strategy and you don’t like the banks 🙂
I’ll cautiously play small to start. “Watch this space”.
2am here, bed time. Have a good weekend.
This was a long time ago, but Duc – I was right.