(I am writing this article because I have had feedback in the past from investors who reject covered call writing based solely on the theoretical risk-rewrad profile.)
A risk reward profile is a chart of the theoretical maximum profit or loss a particular investment can have in your portfolios. For example, let’s look at the risk-reward profile of stock ownership:
This graph demonstrates that, in theory, profit is unlimited; it can go to the moon! You can also lose your entire investment. For savvy investors, will either of these events ever occur? No. Even, the most solid of companies will hit bumps in the road and give us reason to sell some or all of our shares. Furthermore, which educated, prepared investor will allow his stock price to drop to zero?
Theoretical Risk-Reward Profile for Covered Calls:
Let’s analyze this next graph:
Risk-Reward for an Unmonitored Covered Call:
When selling a covered call option, we are placing a ceiling on the share appreciation; our profit is limited to the option premium plus any stock appreciation up to the strike had we sold an O-T-M strike. The downside is dramatic as we can lose all our equity value and retain only the cash from the sale of the option. If we were to base our decision regarding the efficacy of covered call writing solely on this profile, we would reject it immediately. It appears that the odds are against our success. Fortunately, there is a major difference between theoretical and practical applications of risk-reward profiles. Enter the wonderful world of exit strategies.
Practical Risk-Reward Profile for Covered Calls:
Let’s now analyze an enhanced graph that has application in the world of the informed and prepared investor:
The actual profit potential can actually be elevated in some instances by instituting one of our exit strategies. Certainly the potential losses can be minimized by utilizing any of these strategies. Some investors buy puts to limit losses. This is called a collar strategy and will be discussed in future articles and perhaps a future book. Here is the key point uneducated investors miss: This horizontal line that represents potential loss can be elevated closer to the zero line by instituting appropriate exit strategies, selecting the best strike prices, factoring in market tone and equity technicals. These are the marks of true Blue Collar Investors and are what set us apart from all the others.
When evaluating information to make an intelligent investment decision, we must know the limitations of that tool, in this case the risk-reward profile, so we can apply it in the proper manner. Viewing the last graph as compared to the one before it demonstrates the significance of this point.
In last week’s blog I mentioned that the IBD 100 list was being enhanced to the IBD 50. That change became effective in this week’s edition of the IBD. I checked the criteria used and found it to be exactly the same as the IBD 100. I cannot attest to the percentages used but the parameters are the same. When I spoke with tech support at IBD I was told that the list basically will be the top 50 of the former top 100. Here is what IBD is publishing regarding the enhanced list:
- Less is more
- Focus on variables that separated the great from the good
- List that is faster and easier to study
- Higher success rate
- Eliminate more volatile stocks
One of the things that attracted me to IBD was the fact that they are always working towards improving the quality of their already stellar products. This, initially, appears to be such an upgrade. We at the BCI will continue to evaluate, monitor and report back to you on this screen and its impact on our covered call positions. We are expecting 2011 to be a great year for the BCI community!
This was an extremely light week for economic reports. The Conference Board’s index of consumer confidence unexpectedly fell in December as economists were anticipating an increase due to the extension of the Bush-era tax cuts. This decline was a result of concerns regarding the state of the job market. Consumer confidence, however, is still on par with the confidence levels of a year ago. For the week, the S&P 500 rose 0.1% for a year-to-date return of 15% (including dividends).
IBD: Market in confirmed uptrend
BCI: Moderately bullish. My outlook for 2011 is positive. Economic reports, corporate earnings and government tactics have been favorable to the market. The two major hang-ups continue to be unemployment and real estate. When these turn around expect the ride of your lives as there is still trillions of dollars on the sidelines waiting to enter the equity markets. Of the two, I am more concerned about unemployment as I feel the bottom of the real estate downturn could happen later in 2011. Many of you know that I am heavily invested in real estate as I own both commercial and residential properties in four states. I am seeing property values starting to stabilize, renting much easier in both the commercial and residential arenas and banks just starting to make cash available. We have a long way to go but the early signs are encouraging. My hope is that once real estate bottoms and turns around, it will impact the jobs market in a big way. Construction will pick up, basic materials will be in demand, home furnishings will be needed and a trickle down effect will mean happy days for the stock market. As a rule, the stock market precedes the economy as it is forward looking and 2010 was a decent year for the market and the BCI community. As educated investors we know that there are no guarantees but the signs are generally positive and that is why we continue to remain bullish on the stock market. Let us know how you feel.
Wishing you the best in investing,