Writing Covered Call Options To Boost Returns On Stocks

| June 4, 2008 | 0 Comments

You read the title right.  Over the last two months I doubled the return on one of my investments.  This isn’t in theory.  This is an actual trade I made in my retirement account.  It’s easy to do, and you can do it to.

Regular readers know that every once in a while I write about trades that I make.  Today’s one of those days.  I’m going to let you look into my personal investments, something usually only viewed by my tax guy and lawyers.

But before I go any further a word of caution.

My trading limits might be significantly different from yours.  You and I might have very different financial situations, risk profiles, and experience levels.  So don’t just blindly copy what I do.  Before you make any investment, make sure you know your limitations and risk tolerances.  And most importantly, make sure you understand what you’re doing.  It’s your money and nobody will care for it more than you.

Ok, onto the trade.

Now, I know what you’re thinking.  How did he double the return on an investment in only 2 months?  The answer is simple.  I know a “secret” trading technique that puts money in your pocket every time you use it.

And it’s easy to do.

As I mentioned before, I did all this in my IRA.  My IRA is where I hold my long term investments.  The securities I buy in this account I plan to hold for a very long time.  As Warren Buffett famously quipped, “Our favorite holding period is forever.”  I feel the same way.

I’m not going to bore you with a list of everything I hold.

What I will do is share with you a technique used by a great many institutional money managers and serious investors.  It basically adds cash to your account almost every month.  Not many people do this.  But almost anyone can.

Here’s the trade.

Back in April I started doing research on the REIT market.  In my research I uncovered a number of interesting data points.  I liked the trade so much I wrote an article about it:  “My Latest Trade . . . .”  If you haven’t read it or don’t remember it, take a quick look at it now.

So, what did I buy?

I bought the iShares Dow Jones U.S. Real Estate Index Fund (IYR). This ETF holds a selection of some of the best REITs in the market including:  Annaly Capital (NLY), ProLogis (PLD), Simon Property Group (SPG), and Vornado Realty Trust (VNO).

The ETF is well diversified and it pays a nice dividend.  I also noticed the price had fallen from a high of over $95 to the low $60s.  I bought IYR for my IRA around $66.50.

Now I’m perfectly happy sitting on this investment.  I expect in 10 or 20 years it will be significantly higher in value.  As I write this, about two months later, IYR is trading around $68.25.  This gives me a return of 1.75%.  Not bad for a few months, but nothing to get excited about.

But I wasn’t done.

Here’s the secret to improving your returns.  IYR is a nice long term investment, but it’s not very volatile.  That makes it a great security to write covered calls on.

If you don’t know, “writing covered calls” is a basic options strategy.  You sell a “call option” against a security you already own.  When you sell that option, you take on the obligation to sell your security to another investor at the “strike price.”  In exchange they pay you a “premium.”  Cold hard cash, up front.

So this is what I did.

First I bought 100 shares of IYR at $66.50.  Then I sold one call option on IYR.  The “strike price” was $73 and the “premium” was $1.55.

This meant that I agreed to sell my shares of IYR to the investor who bought my option at $73.  I’m obligated to do this.  If IYR rockets to $100 I’d still have to sell at $73.  For taking on this risk I got to collect an immediate payment of $1.55 per share.

Remember, there’s 100 shares in every options contract . . . it makes the math really easy.  So I got paid $155 for selling this option.

One more detail.

The option I sold was a June option.  This means that the investor who bought my option has until the third Friday in June to exercise the option.  If he doesn’t exercise the option by then, I get to keep my IYR shares and his money.  Might this option get exercised?  Maybe, but I don’t think it will.  There’s only 12 trading days left.

Now I know what you’re thinking.  $155 doesn’t seem like much.  But do the math.  It works out to a return of 2.3%.  So while my IYR shares are up about 1.75%, my option trade added 2.3% on top of that . . . That’s how I doubled my return in 2 months!

Here’s the truly amazing part, I sold an option that was about 2 months out.  That means I can do this same trade 6 times a year.  A little back of the envelope math and you’ll realize that I can make an extra $933 every year (6 x $155 = $933).

That’s an extra 14% per year for just a few moments of my time.  And, I still get the dividend (which would add another 4.5%).  Now we’re looking at an 18%+ return even if the stock doesn’t move.  That’s more like it!

Now keep in mind, I didn’t include transaction costs or taxes to keep this example simple. . . you’ll need to pay both.

So here’s a question for you.

Have you ever made a trade like this?  Do you have experience with covered calls?  Do you have a story about making money with covered calls?

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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