I received an email from a client this week asking me to take a look at a promotion they had received. It stated returns for a Covered Call position, a strategy I’ve been using for a decade with great success. But when I crunched the numbers, it seemed to be a little bit mis-representative.
Any good business owner knows that being able to read and interpret your financial statements is essential in knowing how your business operates. It allows you to understand where your strengths and weaknesses are, and to identify whether there is a change that requires attention. Such as increasing operational costs for example. The same is true with trading.
The email promoted a return that, even in my 10-years experience with this strategy, was almost double the average return that I have as a minimum. What many of the readers would not have considered is the fact that the higher the return, the greater the Risk.
Risk versus Reward
Any time you invest capital, whether that is in shares, property or business, you are evaluating the Risk and the Return of that investment. If you invested $1,000 and established an expectation of a $500 return, you would expect that there was a high probability of losing the total $1,000. But if you expected a return of say $10, you would not Risk much of your $1,000 at all.
The promotion material stated a return of 7%. It even provided an actual screen shot of a trading account to prove the numbers. But here was where the first flaw was established. The real return (if Exercised), was actually only 4.9%. That’s a huge difference in what was being promoted.
Putting that aside, I then set to task in evaluating the actual stock and the Risks associated. This is always my first approach to analysis – defining the Risks.
I found that the underlying company was scheduled for an earnings announcement 10-days after the promotion was sent. By promoting a high return Covered Call on a company that was scheduled for earnings during the life of the position confirmed my view that who ever had chosen that position was only looking at half the equation – always a dangerous thing to do. This is why we use 4 very robust rules to avoid such a dangerous trap. To find out more click here.
One of my key rules to the Covered Call strategy is to not sell calls against stock ahead of an earnings announcement. Especially if we are not in a Booming/strong economy. The Risk that the company will disappoint market expectations and cause the stock price to gap down is far too great. And so we established the 2nd flaw.
Further investigation into the company’s earnings revealed that the share price had fallen heavily on the previous 2 earnings announcements, and for me, that established a high probability of Risk that the underlying share price would fall on the next announcement. In other words, stay clear, as there are probably better opportunities out there with less risk.
The lesson here is that it pays to learn how to read financial statements. Find yourself a trusted advisor and question everything. This type of return is not too good to be true. It is quite achievable during certain market conditions. However, you need to know how to find a suitable trade, manage that trade, and how to react to various market situations to successfully make this strategy work for you.
Follow up note: The company in question released their earnings and fell 20% the following day.
Through the 3rd quarter earnings season, from the 20 odd Covered Call positions that I managed, (those closed or held) none of these positions gapped down with such veracity. This is the exact reason why I have such rules in place as more than a decade experience with this strategy has taught me some very valuable lessons.
Crunching the numbers, any client who had entered into the 7% trade, as promoted, would be at least 10% down in their position, and it would be my guess that most of those traders who continue holding on, in the belief the share price would recover, may wear more pain. Very different from what perhaps they were expecting on entering the trade and why it is so important to be able to crunch the numbers accurately.
Matthew Brown – US Stocks & Options specialist
US Equity & Option Client Advisor
Halifax Investment Services
ASIC Australian Financial Services License Number – 225973
If you would like to learn more about the strategies you can use to profit from any type of market direction, visit http://australianinvestmenteducation.com.au or you can contact Matthew on firstname.lastname@example.org
Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms. For Discount platform services, Halifax charges the same fees for phone service as the online trading platform.