Why should Covered Writes be Illegal?

Now that I have your attention, why the  dramatic  title?  Let’s start with a discussion of what covered writes  are , then lets get into a discussion on a better alternative.

Covered Write example: Buy 100 shares XYZ at $90 and sell 1 August 95 Call at $1.

Your generally buying stock and selling  an out-of-the money call against the long stock. Why would someone do this versus just buying the stock? Extra Income. As long as the stock doesn’t go up too much over a designated duration, you can make money on the stock appreciating and also some additional  income from the call your selling , as long as the stock doesn’t appreciate past the short strike. What’s the problem with this trade? Cost! In a retirement account, you would have to put up the full value of the stock minus the premium of the short call. In this case, you would pay $9000 for 100 shares of stock minus the  $100 premium from the short call, or $8900. What is a reasonable monthly yield on this type of strategy? About 1%. Is that bad? It’s not horrible, but for the risk and capital you have to put up, there are better alternatives. Like what? Long Diagonals! Example: Buy 1 Feb 2019  75 Call for $18 and sell 1 August 95 Call at $1. Why is this better? Cheaper and better Yield! Why cheaper? The cost is the long option minus the short option or $17 in this example. Why better Yield? Substituting an In-the-Money call instead of Long Stock requires a much cheaper capital outlay. The yield on the Long Diagonal in this example  is $100 premium divided by $1800 or 5.5%. Yields are usually 8-10% monthly on Long Diagonals,  this self made example gives you a visual of the Long Diagonal, but understates the potential yield. The yield on the stock is much lower because your dividing the premium by the full value of $100 shares of stock. For most of you, how would I recommend practically learning this strategy? If you are doing this strategy in a particular stock, start with 1 Long Diagonal in a stock you are already doing covered writes, and this will give you a feel for this strategy. When you start this strategy, what duration should I do and what strike should I sell?  Usually I do 30 day options. If neutral on the stock, I sell an ATM call, If Bearish , I sell an ITM Call. If Bullish , I sell an OTM call. What stocks should I do Long Diagonals in?  Stocks I am Bullish on over the next 6-12 months.


Dan Sheridan


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