Podcast – Episode 137 – Pitfalls of the Poor Mans Covered Call

Podcast Transcript

Do you have questions about trading? And about Options? Or maybe investing? Well, if you do, ask, and we’ll get you an answer. So in our Facebook group, which is a public group, anybody can join, you can go there by going to freeoptionsgroup.com, FREE-OPTIONS with “s” group.com. You can go there. And there’s a post called the post of 1000 questions. And really, the idea there is for you to ask your question and get them answered by somebody who actually trades. Because when you go online, you never know who’s going to respond to you.

Case in point, we got a question from Mark Baumgarten. And thank you, Mark, for your question. I’m gonna go and read that in a second. But, you know, Mark asked this question, and somebody responded to him and gave him the wrong answer, even in our group. So, yeah, you never know what answer you’re gonna get. And you know, if he’s gonna be accurate or not, so, you know, this post, I think it’s a good way for you to get an answer. And like I said, you know, I’m making this to answer the question. So we’re gonna get, do our darndest to get you an answer. One way or the other. You know, if we’ll make a video about it, maybe we’ll just shoot you a couple line email or message you on Facebook and say, here’s the answer. But if you have any questions about trading, I’ll again, can give you personalized investment advice. That’s not our job, right? You have financial advisors and planners and Wealth Advisors for that. But if you have a trading question, then go ahead and post it in the program, or sorry, in the group there, and we will get you an answer. So here’s my question. It says:

“I have bought a leap call expiring about 24 months out and have been selling weekly calls on the leaps for the last six months. Has anyone had problems with this strategy? What are the pitfalls to watch out for? So great question. Basically, what Mark is describing is a, you can call it, it’s called a couple of different names. “Poor Man’s covered call”, is one name, “Synthetic Covered Call” is another one.

Basically, what he’s doing is he’s doing a covered call on a cover call is where you own 100 shares of stock, and you sell call options against it for the income, this is the same thing. But instead of having the 100 shares of stock, he’s using a long dated meaning far from expiration call option. Now the one thing I don’t know, Mark, is what strike your call option is at normally, with a poor man’s covered call, you want to sell a covered call that is deep in the money, because you want it to not fluctuate in price as much because of the option, right? So options are not stocks, they do evaluate, they do go up and down due to volatility, the stock price will not do that as much. So there, it’s definitely different. In some ways, the theory is the same, you know, you have an asset and you’re selling options against that asset. In this case, it’s a long call. So 24 months out, that’s plenty of time, and you’re doing weekly, so that’s good. So you have, you know, four expirations every month, the idea here, and the goal is to get your money back on the long call. And if the stock goes up in value, hopefully that long call makes money. So you can sell that at a higher point as well as get your money back. And then I’ve seen people make 20, 30, 40% in a year on this type of strategy, compared to a covered call, which might make you know, 15, 20% in the same timeframe if the stock rises, so you can make more the benefit. And the thing that appeals to people is that you don’t have to buy those 100 shares. So you have a greater percentage return because you have less money invested. And so this also helps people with smaller accounts. Now, you can also use margin and buy 50 shares, and then use margin to buy the other 50 shares to do it. But this works out too. I don’t particularly I’m not a big fan of the synthetic covered call, because we never know what the stock is going to do. And especially in a market, you know, the cover call and the synthetic cover call are good strategies and bull markets, you know, when the stock is going higher. We are not in a bull market right now I don’t know if the stock is gonna go sideways, it’s gonna go up, we’re gonna go down most likely, it’s gonna go with whatever the market does. And my opinion is the markets probably gonna head sideways to lower from here, but it goes up and down and up and down and rallies and decline, so..

the thing is, you don’t want to be called away. So you don’t want your short call to get in the money, which is a problem. You don’t want too much time decay to affect your long call. That could be a problem. As you know, the months go by and it gets closer and closer. Now you went out 24 months. So I mean, you paid a hefty premium for that. You paid a lot of money premium. I would look at that versus okay, depending on what the stock is, I would look at that because if there was a lot of volatility you might have overpaid, but I’m gonna assume that you didn’t. Now, the pitfall is if the stock goes down, if the stock itself, the value goes down, your long call will also lose value.

Now, if you own the stock, you don’t have any problem, because even if the stock drops to very low, you can still hold on to it, yes, you have a paper loss, but you still hold on to it, you can still sell covered calls against it, you can still do covered calls against it. And it might take a year, two years, three years, four years, five years. But eventually, it might recover. And until then you still have that asset that you can still cash flow by selling the covered call, with the you know, the long call, you have a deadline, right? Every day that goes by the value of that asset is going down, you’re losing value, so you have to recoup that. So a lot of people say, hey, you know what, I think 24 months might be a little bit too long to go out. But you know, if you’re talking about, hey, I don’t want the theta decay that might be working, I would definitely back test it. You know, I haven’t, like I said, I’m not a big fan of these. I’ve tried them in the past, I haven’t gone out 24 months. So I have the most I gone out was about 12 months. And so they did work if the stock was generally in an upward slope, in stocks where we were going sideways, I was losing value on the on the call option every month.

And so it was it got harder and harder at the end to recover from selling call options, what money I could make what I was losing on that long call. And if the stock drops, then you’re actually collecting less premium, right? Because let’s say the stock drops from 100 to 50. Now each option that you’re selling is also worth less, so you’re getting less and less, and it doesn’t recover the loss– it doesn’t recover the loss on the call. So that can be a big detriment in your pattern. So if you if you suffer a large loss, we had, you know, Facebook meta has been down 60-70%. So on a stock like that you would be down big time, you’d still be down if you own the stock, but again, you still own the stock, and there’s a chance, you know, eventually it might recover and go up, and you can wait for it. With the long call, you cannot wait. So that is the biggest problem. Some of the other people were saying, hey, you know, you got to watch out for the stock to drop to zero. Well, that’s, of course, you know, anything. Yeah, there was that. Steve was replying that, you know, his experience with the LEAP call moves around enough to negate the income from the weekly call. So yeah, you know, it just it fluctuates enough that the volume or the premium that you’re getting from the sold calls, doesn’t equal to the negative Theta decay. And there were a couple other replies here. So I think you know, that would be the biggest fallback, you know, it’s a, it’s a good strategy, if you don’t have money in the beginning, if you’re if you’re just getting started, it’s a good strategy to go from there. But if you do want to get into covered calls, I would probably recommend instead going to something a stock that’s even cheaper. And then starting with something like the wheel, you know, where your selling points. And then if you get assigned, then you sell the covered call right at the money and use leverage and margin to do that. Other than that, I haven’t seen too many professional traders or even long term traders that are not professionals rely on this strategy for a long period of time. It’s more of a beginner strategy.

You know, when you get started, you don’t have enough capital. After that, like, I’ve done covered calls on stocks that I’ve owned for eight years, 10 years now. And part of what we say at passive trading is that you want to build a foundation, right? You want to own high quality, good stock names that pay you dividend with the synthetic covered call, you don’t get the dividend. And every time there’s a dividend paid out, the company loses value. And so the stock on your option will drop. It’s actually supposed to drop every time you take money out right as paying a dividend. As a shareholder, you collect that dividend as an option holder, you pay that dividend. So you don’t necessarily pay out of your pocket, but the value of the company drops and so your call option will drop in value. That’s another one. But if there is a large downturn, you know, you’re going to take a big hit, your value will go down very quickly and you will not be able to recover. If you do own the stock, then you have plenty of time to wait and let it come back up. One of the most infamous for me anyway, covered calls I did was on Las Vegas Sands. And I think I bought the stock around 17 and the stock ended Going all the way down to like $1.75 or something, you know, but I held on, I sold some of it. But the rest of it I held on and it recovered. The business was rumored to go out a bit. He was rumored to go out of business, but they they were able to save themselves. And then eventually, I sold the share somewhere like 40-$50.

So yeah, I made money off of it. But yeah, it took like six years, right? With a synthetic covered call strategy, you don’t have that option. So it’s in terms of a bull market, great time to use it. In terms of a bear market, not so good. There are other strategies out there that you can make way better returns on, you know, I would probably look at the covered call. Now the cover call, the credit spread, would be a choice that most people would probably go to over this better returns, you’re in and out, you’re not stuck in the same trade for 24 months. And you’re not stuck in the same stock. Right? So unless I own the stock, and I can wait it out. I don’t want to be in an option trade for more than a month at a time. You know, there’s just too many variables and too many things that can happen. I don’t want to be long options, or even short options more than a month at a time. So that’s my two cents on that. Hopefully this will help you mark, you know, it’s not that it’s a bad strategy, it works, it’s just that there are other ones that are probably better off to accomplish what you want to accomplish. Because it’s not a covered call for me. It’s “Hey, I own this stock, I bought this asset that I’m going to own for a long period of time, I’m going to sell covered calls because I want to reduce my cost basis, or I just want the income”, right? “I want the income coming in every month”. With a synthetic covered call. It’s not about income, it’s about the return, you’re trying to make a larger return. There are better ways with other options, strategies that you can make a better return and take maybe less risk. So that’s my two cents there. Again, if you guys have questions, you know, go to free optionsgroup.com, find that post. It’s called 1000 questions, and go ahead and put your question in there and we’ll be happy to get your answer. Thanks, guys. Trade with the odds in your favor. Take care.

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