Why professionals love Covered Calls, but Mums and Dads fail to see the benefits: Your first experience with stock investing was likely to have been a “Buy and Hold” approach. From an early age, we are taught to Save, don’t use Credit, spend only what you can afford to spend, and pay off debt as quickly as possible. All good advice, but not necessarily the actions that create wealth. These are tips on how to manage your finances, not strategy to create cashflow.
I started my professional career as a Technical Analyst, or chartist. This was before electronic trading and brokerage platforms. Where to buy or sell shares you needed to have a relationship with your broker. Information was not as easily available, and there was a mystery to the stock market.
What Charting provided me
Charting provided me with an edge. That is, a point of difference that allowed me to outperform the broader market. Finding an edge now days is a lot more involved than simply applying some charting techniques. In the modern world of investing and trading, strategy is pivotal, understanding how the markets work (that is experience), provides a better understanding of what is achievable, and knowing what to trade during different market conditions is the most challenging of tasks.
Gaining experience takes time. And it’s not just experience in buying and selling, but experience in the median you want to trade. Stocks? Options? CFDs? Currencies (FX)? Futures contracts? Commodities? There are many ways to skin the cat, as they say, and most people are only aware of buying stocks for investment. Yet, with a limited knowledge of how to achieve a return from trading, Mums and Dads will approach the stock market primarily with the hopes and dreams of making it rich. Do you fall into that category?
I’m still an advocate for stock investing, or positioning (with regards to medium-term strategy). Stock investing makes sense to the average Mum and Dad. However, you are not going to make a fortune from stock investing in a short period of time.
Don’t get me wrong. I’m not trying to spruik a ‘get rich quick’ scheme here. Investing in stocks is preferable for most Mums and Dads, however, they tend not to understand how to manage their portfolio and the Risks associated with the stock market.
The greatest Risk is that stock prices fall. Believe me, it doesn’t matter how much time you spend analysing a company, or whether the biggest research firms in the world designate it as a Strong Buy or AAA rating. If market sentiment is weak or there has been a negative announcement associated with the company or the industry, the stock price can fall in value.
Covered Call Strategy
It is for this reason that we manage positions using the Covered Call strategy. We have many articles explaining how this strategy works, so I will let you scroll through these few links:
The key to this strategy is that our approach is not for the stock price to rise and therefore to make a ‘huge’ return from a capital gain. The mindset for this strategy is mathematical. We identify fundamentally sound companies that technically appear to be at reasonable buy levels, and we enter a Covered Call position to benefit from Time Decay in the option price.
Now, this might all sound like double dutch to you. And rightly so. The Options market, which is a ‘derivative’ of the stock market, uses terminology and concepts that many people don’t believe are real. To highlight, the Covered Call strategy can be profitable if the stock rallies, remains sideways, and sometimes even if it retraces slightly.
In simple terms, this strategy reduces the cost of buying shares. The flip side is that you Limit the capital gain you can make in the stock. So if your mindset is that you want to make huge gains from selecting the next greatest company discovery, then this strategy is not for you.
If your mindset is, however, that you are willing to turn your positions over on a regular basis (our approach is month to month), reduce the Risk of your stock position by selling call options, and to become “option premium hungry”, then this strategy might be for you.
Stock markets rise and fall, and your success as an investor not only is dependent on broader economic conditions (expanding economies), but individual company performance. Choose wisely (strategically in professional terms), and your portfolio of companies should perform in accordance with the broader market. Throw in a little bit of luck and you might choose some stocks that outperform the markets, and you achieve a better result. A little bit of ‘bad’ luck and you might choose a company that releases some unwanted surprise information, and therefore underperform the broader market.
What the Professionals do
Professionals use the Covered Call strategy extensively. So much so that in there are indexes that represent the strategy on both the ASX and US stock markets (it is also referred to as the Buy Write strategy). Extensive studies have been conducted to compare long-term results. Of course, a strong stock market such as we had experienced in 2013 will see the Covered Call strategy underperform because capital gains are limited due to the nature of the strategy. However, for those investors who are concerned about individual stock risk, the Covered Call approach reduces the cost of buying stock due to the premium you receive for selling shares.
Markets today are faster moving, with a plethora of information available to sift through. The basic approach to investing is to Manage Risk and to Meet broader market performance. But that approach is harder and harder as the markets become more volatile, requiring more time to hold your investments to meet your targets.
The Covered Call strategy is becoming more popular as Mum and Dad investors learn more about how to manage their Risk, and start looking for alternative strategies to the traditional Buy and Hold approach.
To learn more about these strategies Click Here.