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What are realistic expectations for covered call writing? Alan Ellman shares how much you can make with this option strategy.
My guest today is Dr. Alan Ellman and we're talking about covered call strategies and the expectations you should have in terms of monthly return on your portfolio. So, Alan, talk about that. Should I be expected 2%, 5%, 10%, what's a realistic expectation?
Realistic expectation really is based on your own personal risk tolerance. For example, many people have contacted me over the years and said this and this person or this and this Web site is promising a 6% to 10% one month return on covered calls. That type of return is only possible if you're selecting high beta stocks. Those are stocks with very high historical volatility and options that have high implied volatility. So in other words, they're extremely risky. Now, I'm a conservative investor. I'm sure most of your members are as well. You don't want to lose money so what I do is I target. My sweet spot is 2% to 4% initial profit. So the implied volatility of that option or the time value of that option will return 2% to 4%. Now, at the end of the month, the position of the final returns will be dictated by the share price. So if the price of that stock goes up to the strike price if you wrote an out-of-money strike, your returns will be even higher for that position. If the share value declines and your shares are sold, then it'll be subtracted from that position. But to answer your question in general, in average market conditions, my goal is 2% to 4% a month.
And in times of low volatility like we've seen in the early part of 2012, that may be increasing now, but is it tougher to make that 2% to 4% or would you rather see a little bit higher volatility in order to do that?
Well, if you have a good solid watch list, which from my comfort level is 40 to 60 stocks, you're going to always be able to find those equities as underlying securities that will generate that type of return and what you can do to compensate is to use more of the at-the-money strike to generate that initial 2% to 4% return. But you must also make a firm market assessment and you must also look at the chart of technicals to make your final decision as to which strike price he used. But to answer your question, if you have a good solid watch list of the greatest performing stocks in the greatest performing industries of 40 to 60, you're always going to find enough securities to get you 2% to 4% a month.
Alright, and in achieving that 2% to 4% a month, should I be writing covered calls for the entire amount of stock that I own or maybe half of it, what do you recommend?
A lot depends on your portfolio and the amount of cash that you have in your portfolio. What I use as a guideline for most of my members is at a minimum, you should have at least five different stocks in five different industries to have adequate diversification. Now, there is a way of circumventing that. You could write covered calls on exchange traded funds. As you know, those are mutual funds that behave like stocks and when you buy any exchange traded funds, basically you own a basket of stocks, so you're almost automatically diversified, so you can have less positions and still have the diversification. That's a strategy I use in my mother's account. I use ETFs in her account. For me, I use individual securities so you get a higher return for the individual securities because there is more implied volatility than there is in a basket of stocks as you would have in an ETF.