Covered call writing is a conservative strategy for cautious investors. We want the higher than risk-free returns with the least amount of risk. One question that does come up in this regard is why not enter a short-term trade that offers impressive returns? To get an understanding if this is a beneficial approach there is nothing like a real-life example to dissect every aspect of such a trade. I will be using Sarepta Therapeutics Inc. (NASDAQ: SRPT) to highlight the key aspects of this article.
SRPT: 3-day trade from June 6, 2016 – June 9, 2016
- 6/6/2016: Buy SRPT at $15.40
- 6/6/2016: Sell $16.00 call at $1.90
- 6/9/2016: Plan to close trade prior to expiration
The multiple tab of the Ellman Calculator shows a 3-day initial return of 12.3% with the possibility of an additional 3.9% if share price moves up to the $16.00 strike by expiration. This annualizes to between 1000% – 2000%. I don’t know about you but I’m beginning to get nervous!
Here’s what we know without even 1 second of research
1- We know that options returns of this magnitude and time frame are based on an underlying security with massive implied volatility. This means that the market is anticipating huge price movement in either direction. Frequently, this will results in gap-ups or gap-downs…sudden and dramatic price movement. Is this what we want as conservative investors where capital preservation is a top priority? (hint…no). To confirm this, let’s have a look at a 1-year price chart for SRPT showing two gap-downs of over 50% each time:
Neither gap-down was related to an earnings report but rather the nature of the underlying security.
2- We know that there is a likelihood of some event expected that could rock the share price in either direction. We have eliminated earnings reports as that event due to our standard screening process.
Checking the news: www.finviz.com
Sure enough, there was expectation of a news announcement by the FDA regarding a muscular dystrophy drug being developed by SRPT:
The risk is now explained and the question is should we be enticed? (hint…still no).
So what happened?
Clearly the trade had a happy ending with a 3-day return of 16.2% (12.3% + 3.9%) as share price moved from near$16.00 to near $21.00 (brown field). Is our conclusion then that short-term volatile trades should be a recurring aspect of our trading strategies (hint…well you know).
For Whom and when should such trades be considered?
Trades which offer huge short-term potential profits are highly risky trades which make a lot of money or result in extensive losses. They are for traders with high risk-tolerance looking to hit it big. Covered call writing is on the other end of the spectrum, most appropriate for conservative investors who stress capital preservation. Should such a high risk/reward trade be entered, a covered call will limit the upside but not the downside. In the highlighted trade, $2.50 ($1.90 + $0.60) was generated but it could have been more than $5.00 per share had the call not been written. The major reason for not entering such a trade is the downside risk had the news been disappointing.
Short-term trades offering high returns are most appropriate for investors looking to hit a grand slam homerun with the understanding that substantial losses are possible. With that in mind, each investor must decide which strategy is most beneficial based on personal trading style.
Upcoming live events
1- February 27 and 28th, 2017
Marriott Marquis Hotel, NYC
1:30 PM ET (Monday)
1:30 ET (Tuesday)- This presentation will be webcast by The Money Show
Exhibit Hall Booth 208 (February 26th – 28th) … come say hi to the BCI team
2- March 21st and 22nd, 2017
Two live Florida events (Fort Lauderdale -22nd and Delray Beach- 21st)
3- April 12, 2017
Income Generation Webinar for The Options Industry Council
US stocks continued its rise records this week — including 11 record daily closing highs in a row for the Dow Jones Industrial Average. Investors appear confident that President Donald Trump will cut taxes, reduce regulation and implement a sweeping infrastructure spending program. The S&P 500 Index is up 5.3% year to date and has gained over 21% over the past 12 months. Market volatility increased slightly this week, but remains historically low. Oil prices remained relatively unchanged this week. This week’s reports and international news of importance:
- In minutes released this week, US Federal Reserve officials signaled the potential for a rate hike at its next policy meeting in March relating to potentially increased spending and reduced taxation under the Trump administration, the minutes suggest that the Fed may act more aggressively to keep a lid on inflation
- The central bank increased the federal funds rate to between 0.5% and 0.75% in December and indicated then the potential for three quarter-percentage-point increases this year
- President Trump said this week that he supports a form of the proposed “border adjustment tax” (BAT), a tax on all imports. Trump suggested that such a tax would entice companies to relocate manufacturing operations to the United States, which would create more US jobs. Retail stocks have taken a huge hit in recent months over speculation that a border tax would be implemented. The retail industry imports most goods it sells in the US.
- C. Penney announced this week that it would close more than 100 stores, and rivals Kohl’s and Macy’s announced they would lease some of their retail space to other retailers in an effort to generate more revenue from real estate assets. Under the proposal, US export income would be tax free, which could benefit some energy companies, such as crude oil exporters
- Greece agreed to legislate pension and other structural reforms this week, generating some optimism that negotiations on its bailout terms would resume after months of gridlock. Yields on Greek government debt fell to their lowest level in a month, although serious issues still remain
THE WEEK AHEAD
MONDAY, February 27th
- Durable goods orders Jan.
- Pending home sales Jan.
TUESDAY, February 28th
- Gross domestic product Q4
- Case-Shiller home price index Dec.
- Consumer confidence index Feb.
WEDNESDAY, March 1st
- Personal income Jan.
- Consumer spending Jan.
- Core inflation Jan.
- ISM manufacturing Feb.
- Beige book
THURSDAY, March 2nd
- Weekly jobless claims 2/24
FRIDAY, March 3rd
- ISM nonmanufacturing Feb
For the week, the S&P 500 was up by 0.69% for a year-to-date return of 5.74%.
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of November 10, 2016
BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. How will nationalistic policies fare in a global economy?
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (11.47) declined by 15%.
Wishing you the best in investing,
Alan ([email protected]) and the BCI team