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Today
we're having a not-so-lighthearted look
at one of, if not the, most important rules
in covered call writing. It's not a technical
rule, not one of these precise-measurement
kinds of rules. No, it's a purely common-sense
rule.
Now
that I have you panting to know what my
#1 rule is, without further ado, it is:
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Covered
Call Rule No. 1:
Like the stock.
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That's
it; like the stock. What it
means is that - - assuming you are not called
out of the stock - - you would be content
to hold the the underlying stock in your
portfolio for the medium or long term, if
need be. When you do a covered call buy-write
(buy the stock, write the call), you of
course own the stock. But we expect
to be called out, keeping the premium and
losing the stock for a nice return. But
if you are not called out, you continue
to hold the stock, and if the stock price
is down, your choices essentially are sell
it for a loss or hold the stock for better
times, continuing to write calls on it.
Ah,
but that's the hitch. It is a poor practice
to hold a covered call stock after expiration
just because it is down, just because you
don't want to take a loss. A low-quality
stock may hurt you far worse in the future
if you hold it. It is wise to hold only
the high-quality stocks - really, those
you would be happy to stick in your portfolio.
Liking the stock means simply that you would
be content to hold it for an extended period.
When you hold a stock, it IS in your portfolio.
With
a tip of the hat (and sincere apologies)
to Jeff Foxworthy...
If
you feel the need to keep asking trader
friends what they think of the stock...
you didn't like the stock.
If
your knuckles are white and you're dying
for the trade to be over and be out of
the stock... you didn't like the stock.
If
you feel like puking when you realize
the stock was down at expiration and you
weren't called out... you didn't like
the stock.
If
you wouldn't want to be caught dead with
this stock in your portfolio... you didn't
like the stock.
If...
well, you get the picture.
I
didn't invent this rule and don't know who
did (Wade Cook popularized the concept),
but boy did I learn the power of it. What
I like about the rule is that it expresses
a deep human truth without resort to technical
or mathematical information that makes any
attempt to quantify the value or prospects
of the stock. Therefore I'm not saying you
should like the stock if it is above the
200-day moving average, or has a high Zacks
rating, or has high earnings-per-share growth,
or anything of the sort. Probably no two
investors have exactly the same stocks in
their portfolio, so opinions can differ
radically.
By
"like the stock" I mean that YOU
should like and respect the stock enough
to be content to hold it in your portfolio
if not called out. I might not like the
stock so well, or your brother-in-law the
stock expert might not like it, but the
stock is not my portfolio or his, is it?
It's YOUR portfolio we're talking about.
Writing
a covered call on a stock you're not willing
to hold is the single biggest mistake I
see new and even experienced covered writers
make. This is a gut-feeling issue, friends,
but also more than that. The fact that you
would be content to own the stock for a
possibly lengthy period of time if not assigned
is a very important litmus test. When we
are nervous, fearful or disdainful about
a stock, it is our subconscious warning
us.
This
is not just psychological mumbo-jumbo, either.
On some subliminal level, we know a stock
is flighty, that its quality is low, that
we haven't really analyzed it, that it is
grossly overpriced... whatever. Sometimes,
it's not a subliminal feeling at all - we
know perfectly well the stock is garbage
and write it anyway, hoping or assuming
we'll get away with it before the market
gives the stock its come-uppance.
Conversely,
when you like and respect the stock, you
just feel better about your decision and
are far less likely to second-guess yourself
and make a panicky decision. Put in movie
terms: if love means never having to
say you're sorry, then liking the stock
means never having to say you're sorry you
bought the damn thing. It's bad enough to
have a bad trade without also feeling the
need to beat ourselves up - and we all do
it. Stick with stocks you're happy as a
clam to own.
All
this naturally assumes you know something
about the stock, of course, that you know
why you like it. How else could you
be happy to have it join your portfolio?
These warm feelings about a stock should
be based on knowledge. Whether you know
the stock and follow its fortunes, or whether
you have done the proper homework the proper
way (like CallWriter teaches) you can only
truly like a stock, as I use the term, when
you know it. Anything less than real knowledge
is, well... less.
It
is a real mistake to figure that, even though
it is a stock you'd never be caught dead
holding, you'll just cream it for a few
easy premium bucks by writing calls on it.
Maybe it's just my fevered perspective,
but it seems that it's almost always the
ones we would never want to be stuck with
- the ones we don't really like - that hurt
us. Almost every time a stock has hurt me,
what I knew in all honesty was that I knew
better.
In
picking covered call stocks, ignorance decidedly
is not bliss. Every time we don't do our
analysis on a stock and don't know the stock,
we're ignorant.
This is not disciplined trading, and this
is not "liking" the stock.
The
bad ones tend to stay bad:
The flighty little tech stock that drops
from $30 to $10 probably isn'tt coming back
anytime soon, if ever - it had its overpriced
day in the sun - and you could be in it
for many years. It might, but you certainly
can't count on it. You can sell $10 Calls
on it every month for 0.30 or so as long
as you want, but that is a deep hole - deduct
just trade costs and taxes on short-term
gains and see how you'd do.
On
the other hand, the good stocks are no sweat.
We have a comfort level on those stocks
that is spine-deep, because we know we bought
quality. A hallmark of quality is that things
of quality last. Just as fashions come back
in style, a really good company will have
its day again - it's an investment, in other
words. And even though covered call writers
are not really investors, per se,
it becomes a good investment that you can
continue to sell calls on as long as you
own it. Why?
The
good ones tend to stay good: and thus
they come back. Even stolid blue chips like
WalMart can take a hit. But they come back.
And you can cream them regularly for premium
in the process of getting even. Exxon might
be down, but do you really think the petroleum
business suddenly became unprofitable or
its prospects have more than momentarily
dimmed?
Timing
is not so important. Suppose you really
like the stock, but now is not the time
you would pick to buy it, ideally. Maybe
you would like it better at a lower price.
Maybe for some other reason now is not the
perfect entry time. The question is, if
you are not assigned, whether you will be
annoyed, apprehensive or terrified that
you still own the stock. In other words,
it is about comfort level, not stock
timing.
If
the timing is so off that you just don't
like the stock right now, then you've answered
your own question. Timing or no timing,
don't get fancy. You either like the stock
or you don't. If you start quibbling with
yourself and have trouble making up your
mind, pass on the trade. You don't like
it enough.
If
you're saying to yourself, "That's
it, that's Rule No. 1? Like the stock?"
- the answer is yup. This rule does not
tell you how to analyze stocks or provide
any criteria for evaluating them. And it
is not a way of saying that it's OK to fill
up your portfolio with poor-quality stocks
that you happen to like. Remember: knowledge.
Whatever you process or criteria for evaluating
stocks as possible medium- to long-term
investments, if you wouldn't be willing
to hold the stock for an extended period,
don't write covered calls on it.
There
are many powerful rules that relate to evaluating
and picking covered call trades, all rational
and all time-tested. But you would be surprised
how powerful my Rule No. 1 is. Do your homework
and stick with stocks you have researched
or know well and are willing to own for
an extended period; you'll be surprised
how much better your results are.
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