Deep-In-The-Money Covered Calls: How to Beat Stocks with Less Risk

by Karim Rahemtulla, Investment U’s Options Expert
Monday, January 31, 2005: Issue #180

I am often asked which strategy I like best. My answer is always the same. I like buying stocks and selling deep-in-the-money covered calls against them.

Is this a “boring” strategy, as some investors seem to think? Well, only if you find annualized returns that consistently beat the markets boring.

That’s what we keep doing in my covered-call trading service. And today, I’ll reveal the secret behind those terrific returns – returns that should beat stocks again this year by averaging about 12%.

By using covered calls in your own options trading, you can take the most dynamic, profitable investing tool out there (options) and make it safe as a blue chip stock. Here’s how to beat stocks and lower risk at the same time using options…

Covered Calls: The Beauty of Income Investments

Now in its seventh year, my trading service has been able to maintain a win rate of more than 70%.

That’s right – more than seven out of every 10 recommendations is a winner. The other three are either break-even or losers. Still, some people say that’s too boring.

These days, people want the big numbers… even ridiculous ones, like 10,000% overnight!

Me, I’d rather get rich off boring ideas…

The goal with covered calls is to safely make between 1% and 2% on our investment every month and roll the money over to do it again. That way we create annualized returns of between 12% and 24%.

This month, for example, we closed out five winners – the best returning about 12% and the worst about 2%. All of the open positions on our books right now, about six of them, are profitable and should make us an average of 12% this year alone.

Now, I don’t have a problem understanding these numbers or getting excited about them… Remember, this is a safe money strategy, and it’s only fair to compare apples to apples. Last year we not only beat safe-money investments like CDs – by miles – we also beat all of the stock indexes when our returns were annualized.

So you might say: “Why do you annualize? That is not fair.”

Why Annualized Returns Make Sometimes Sense…

I agree. In most cases annualizing your returns is at best an iffy marketing technique. It is definitely questionable to make 10% in one month and then claim that it’s an annualized return of 120%.

But, hear me out on this one. There are times when annualized returns do make sense, and that’s when the money is continually reinvested to create a steady stream of returns all year long.

When we do an options trade, we have a finite amount of time and are looking for a specific and predictable return. We are not shooting for the moon or hoping “it goes up” and then wondering when to sell.

So when a trade expires, it is over, and if we made 5% in two months, we then roll that money over. That 5% is a real return on capital invested. Period.

Here is how the system works. We buy a stock that we like (this can cost you money) and then we sell an option against the stock (we get money back).

But instead of betting that the shares are going higher, as most people do, we sell deep-in-the-money covered calls. That’s actually a bet that the shares are going down.

By doing this, we do several things. We dramatically reduce our cost, we win if the stock goes up, we win if the stock goes nowhere, and we usually win even if the stock goes down… but not as much as our cushion.

Buying and Selling Deep-in-the-Money Covered Calls

Let me give you an example from real life… We made this trade in October of 2002 but the lesson is just as valid today.

We like Cisco Systems and, using deep-in-the-money covered calls, we had a choice: Either we would own Cisco at $6.30 or we would make 19%.

Both choices sound boring, but let me explain the beauty here…

Cisco was trading at $10 per share. Down from $77, you would have thought Cisco was a good buy on fundamentals. But since the NASDAQ was crashing and burning around you, you really didn’t want to pull the trigger…

So here is what we did…

• We bought Cisco at $10 and sold the January 2004 $7.50 call options against our position.
• At the time, these options were trading for $3.70. So when we sold the option, we got $3.70 back for each share of Cisco. Our cost was now $6.30 (10 minus 3.70).
• Our upside, however, was limited to $7.50 – the strike price on the call.
• Our return on this trade was 19%.

(Our adjusted share price was $6.30, so our profit when our shares were called away at $7.50 was $1.20. Divide the profit by the cost – $1.20 / $6.30 – and you get 19%).

Because we bought deep-in-the-money covered calls, we were able to profit as long as Cisco didn’t drop more than 37% (that is, below $6.30, our cost).

Understanding the Beauty of “Boring” DITM Covered Calls

What a deal! If Cisco went up, you would have made 19%. If it stayed where it was, you would have made 19%. If it went down, but stayed above $7.50, you would have made 19%.

As long as it didn’t go below $6.30, you would have made money.

I liked those odds. And in fact, it was an exciting trade. And a profitable one…

Consider too that covered calls are one of the few options strategies approved for your IRA, so you can even defer your taxes. What’s not to like?

The investors who have joined my trading service are profitable, loyal and very happy. And now you know why: they understand the beauty of “boring” covered calls.

Good trading,

Karim Rahemtulla

Comments

By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.

Check out our selection of daily investment research: