Covered Calls Can Produce Good Profits

I started buying stocks before Ronald Regan became president. I wanted to get good at trading. Longer-term investing made sense, but I always wanted to see results sooner.

It took me a long time to finally settle down and concentrate on approaches that would yield steady, reliable profits. One problem I had along the way was it wasn't always obvious how certain strategies would produce steady profits over the long term. I received endless promotional mailings, attended countless seminars (at least the food was good in Ft. Lauderdale and Chicago), and they all promised endless profits. But with nearly every one, as soon as I started trading them, the losses would outnumber the gains.

I was thick headed and continued to make the same mistakes over and over – I knew what the mistakes were, so I really needed to work on conformance to the rules of the particular system I was trading, consistent and reasonable trade sizing and trade management, and so forth. The passage of years, a divorce, starting a few companies, a daughter, and several more things eventually took the rough edges off me and it all falls into place for me now. But I remember the difficulty I had in the early years picturing how certain trade strategies could work over the long term.

So today I will focus on covered calls – a strategy I finally came to appreciate several years ago. I wasn't initially interested in them because the gains seemed too small, and then when I started to realize the gains can add up to significant amounts over time, I had trouble actually making money consistently because I would panic or overreact at every pullback.

But covered calls can work out quite well over time. And they are universal trade strategies. You can implement them in speculative accounts, accounts focused on the long term, and retirement accounts. Covered calls provide not only income/additional profits, but also help lower the risk. In some ways, they are safer and lower risk than just buying stock outright.

To show how they work, I will analyze a recent covered call trade I proposed in the Seasonal Forecaster newsletter.

In the October 5th, 2015 newsletter, I presented the case for buying D. R. Horton, Inc. stock (symbol DHI). I pointed out the stochastic ‘buy' signals on the daily chart as the stock moved upwards within an up-trending channel. I focused on the strong revenue and earnings growth. I presented the seasonal chart that showed DHI gaining an average 14.4% over the next 16 weeks, with gains in 20 out of the past 23 years (an 87% success rate!). So I added a position in DHI to the Seasonal Forecaster portfolio that morning, at the open price of 29.90.

The stock is up 8.2% since the entry. If you add in the dividend received, the DHI position is now up 8.5% since 10/5/2015. I also proposed an alternative trade of a long DHI January 2016 27 call (that call is currently up about 35%).

In that newsletter I also analyzed a covered call, implemented by buying the stock and selling one DHI October 30 call for each 100 shares of stock bought. This is a more conservative trade than either buying the stock or the long call. Let's look at how it worked.

On the morning of 10/5, DHI opened at 29.90, and the DHI October 30 call was mid-priced, and traded around, 0.84. At this point, if DHI closed on Friday, October 16th (October option expiration day) at or above 30, this trade would return 3.23%, or 116% annualized.

DHI flirted around the 30 level on the 16th and eventually closed at 30.03. The stock was called away and the net profit was $94 per 100 shares of DHI stock (on an original investment of $2,906).

A 3.2% profit over 11 days is decent.

But on the Monday following the 16th, DHI was still looking good. There was no reason to abandon the trade strategy. So first thing on Tuesday morning, it made sense to re-enter a new covered call in DHI. On the 20th, DHI opened at 30.35, and the DHI November 31 call was trading around 0.97.

As November option expiration approached, DHI traded above 32, so the stock was called away at 31. The net gain on the total amount at risk to this point (the cost basis of the November covered call) was 8.7%.

Again, on the Monday after November 16th, everything was still positive for this stock. So a new covered call was in order. DHI opened Tuesday, November 24th at 32.07, and the DHI December 33 call traded around 0.68.

This latest covered call trade is still open, but it is currently producing a profit of $131, assuming we'll get to keep the entire option premium. With the maximum amount at risk so far being $3,139 (the cost basis of the most recent covered call), the net gain on this trade is 13.3%.

The $0.08 per share dividend to holders of record on 11/30 is about to be paid. Let's add this in:

With the profits from the previous two months, and the $0.08 dividend paid on December 14th, the trade strategy, which has lasted two months so far, is on track to return 13.5% on the maximum amount we're risked to date.

If you could earn 13% every 11 weeks, effectively returning 66% a year, would you consider that a good trade strategy?  Do you still view covered calls as a low reward strategy? This covered call position in DHI could be continued for months, if not years, as long as DHI doesn't tank. Right now, the 13.5% gain means DHI could fall that much before we even start losing money on this trade strategy. If we are able to keep doing this, we could lower the cost basis down to $0.00 and end up owning the stock cost-free.

Not all covered call trades work this way. But working covered calls over and over on a quality stock, along with proper management of the trades, can produce strong gains over time.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

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Gregg Harris is the Chief Technical Strategist at MarketTamer.com.

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