In part 3 of our series on selling covered calls I share with you my strategy that seemed to work for a time until it blew up in my face back in 2000.
I was using somewhat successfully a Buy-Write strategy. This is where you buy a round lot of stock and simultaneously write a call option against the position you just bought.
I won’t go into the details here about your reasoning for doing this but you need to understand that selling covered calls, i.e., a call option against shares you already own, means your upside is limited.
But if you think the share prices will stay relatively flat over the time until the call you sold expires, you’ll have juiced your returns with LESS risk.
However, if the shares jump above your strike price, you won’t make anymore gains than what the strike price is.
Conversely though, and this is what got me, what happens if the stock drops in value? Well, you own the shares and thus you’re going to see your value dropping with the share price.
But you did sell an option which proceeded to expire worthless so the hit to the drop in the share price was cushioned to some degree by the option premium you received.
However, what if after the share price dropped 25% you sold another option? And then again, when the share price goes down again?
This is what happened to me with Petsmart. I did a buy write at $30 with a strike price of $35 6 months out.
Petsmart dropped in value so I pocketed the premium I received from selling the call. Price drops to $20 let’s say, I don’t remember the specifics other than the end result which is painful.
I do the same at $20. Sell an option 6 months out with a strike price of $25.
Stock drops to $10. That option expires worthless too so I was able to pocket that premium.
Stock proceeds to drop again, resting a $4. I sell an option with a strike price of $5, again, six months out.
This time the price BLOWS through $5 and the shares are called from me. Yes, I pocketed that premium but I had release my shares at $5 when I initially bought the stock for $30!
So, while the option premiums probably reduced my total cost to say $22, I still lost $17 per share!
Painful example of how an covered call strategy can hurt you if you aren’t careful. I got cocky and paid big time.
Don’t be like me!