How to Diversify Your Cash With DITM Covered Calls
by Karim Rahemtulla, Investment U's Options Expert
Tuesday, April 26, 2011: Issue #1499
Making money on cash is getting harder every day.
Cash just sits there in your account, gnawing away at you because of the paltry returns. If you're lucky, your bank or broker is paying you 0.25 percent each year.
You do have a couple of options regarding what you can do with your cash. First, if you're totally averse to risk, you can put your cash in an EverBank account, where you can earn a little more than one percent on your return - more if you're a new customer taking advantage of their bonus rate.
It's not that much, but it's still a heck of a lot more than your bank is paying you. More importantly, it's liquid. The alternative is CDs, but that would lock your cash up for some time, and the returns aren't much better.
Another option is to play the carry trade. You could invest your cash in foreign currency denominated CDs and capture the higher yields from Aussie dollar CDs or Brazilian real CDs. Again, EverBank has a program that you can participate in to try to capture the outsized returns. But, as attractive as it may sound, you're now putting yourself at currency risk. If the dollar strengthens, currencies like the Brazilian real or Aussie dollar will fall, potentially negating any returns you made on the interest received.
It's a tough world...
Covered Call Investing With a DITM Twist
It's a tough world. At times like these, I personally like to turn to the options market and a strategy that I've been using for almost 15 years now: covered call investing. However, the way I do it has a twist that few people are familiar with.
What I do, and what you should do, is invest using deep-in-the-money covered calls (DITM). By using a DITM strategy, you can accomplish several things:
- Lower your cost of entry into a stock that you like.
- Beat the returns from cash.
- Increase your margin of safety on any trade.
- Capture the dividends that might be available for shareholders, something not available to put sellers.
- Execute trades in any account, including your retirement account, without the need to try to qualify for put selling - which many people cannot qualify for.
DITM covered call investing requires that you buy shares of a company and sell options against those shares. With a DITM strategy, it would mean finding a strike price that's well below the current share price - this is where the strategy differs from conventional covered call investing.
Remember, with DITM, you're seeking good returns on your cash while reducing your risk. Holding cash is considered a risk-free investment, so the object here is not to significantly increase risk - that can be accomplished in the regular portion of your portfolio.
How the Deep-in-the-Money Covered Call Strategy Works
You would buy Cisco at current levels of $17. Against this position, you would sell the Cisco $15 calls expiring in January. These calls are currently paying you $2.70, plus another 18 cents in dividends over the course of your holding period.
To calculate your return on this trade, you need to figure out your ultimate cost first.
- In this case it would be around $14.12 ($17 minus $2.70 minus $0.18).
- The profit potential is your ultimate cost subtracted from the strike price ($15), or $0.88.
- Your return is that $0.88 divided by your ultimate cost, or about 6.2 percent in this case - dwarfing the returns from cash.
Your downside cushion is 17 percent - meaning that Cisco would have to fall 17 percent further from the current price before you were faced with a loss.
- If Cisco stays at current levels, you make 6.2 percent.
- If it falls, but not under $15, you make 6.2 percent.
- If it goes up, you make 6.2 percent.
You can only lose money if it falls below $14.12 (your ultimate cost). At that level, you would own a world class, cash-rich company at levels that most people, including myself, would consider a bargain.
"Cash is King," most of the time. But, if left sitting for long periods of time, cash can quickly lose the battle against inflation. It's important to have a strategy if you're holding cash, and the deep-in-the-money covered call strategy is one to think about in the future.