Sunday, March 17, 2013

My First Covered Call

I remember selling my first covered call very vividly as it was a life changing experience. It was early 2000 just before the NASDAQ bubble burst and the stock was CSCO. A friend of mine had called and sent me to Yahoo Finance website and tried to explain to me how a covered call worked. The option chain and terminology was too confusing for me, I didn’t get it. He tried again a few weeks later and it was still Chinese to me. For some reason the third time through it clicked and I had the same experience that many have, you ask “Why doesn’t everyone do this?” I thought there must be a trick, I couldn’t be understanding it correctly because I would have heard about this by now, etc. You have to remember this was the year 2000, long before self-directed investing was the norm. Commissions were high relative to today and not every broker even offered you the ability to trade options. I remember having to jump through hoops signing documents and taking a test just to prove I knew what I was doing, which I didn’t.

I thought I did at the time but in retrospect it’s obvious I was clueless. Though I did understand the risk/reward of a covered call, I didn’t know what implied volatility was. All I knew was that CSCO was trading at $39 and I just sold a $40 strike price call for $3.40. I don’t remember the numbers exactly but they are in the ballpark. It was only a few days prior that I had finally understood the mechanics of a covered call so I was excited as hell to press the button knowing that no matter what happened to the price of that stock, I just pocketed $3.40 x 1000 shares = $3400. I literally remember feeling giddy inside and even asked myself; well doesn’t this mean you are kind of semi-retired? Because at the time the tech bubble had yet to burst, I think my account balance was $300,000 and I had only written one covered call on a portion of my holdings. This falls in the category of if its sounds too good to be true, it probably is.

Needless to say the tech bubble burst later that year, CSCO finally got its ass handed to it, my account balance fell far from its peak. My only solace was that I had lowered my cost average on that purchase by a significant amount by the time things settled sometime after the 9/11 bottom. It wasn't until the markets bottomed and volatility settled down that I started to realize how little I knew. The inquisitive moment came when for the third month in a row I sold the same covered call strike price of $27.50 but the prices of the calls kept going lower. Again, I don’t remember the exact numbers but let’s just say I got .60 the first month, then .40, then I clearly remember seeing the bid was .15 and I thought, I can’t sell that, why would I limit my upside risk for only .15? Didn’t I get $3.40 for my first call a year ago? WTF is going on? I guess I’m not semi-retired anymore. I heard that term implied volatility again on TV so I decided to look it up, I hadn’t any idea what the hell they were talking about. But it planted a seed, and a few years later I finally put the time and effort in to learning more about this magical tool that changed my life.

Some twelve years later I've written literally hundreds of covered calls and profited well over $100,000. But there have been trading losses and stocks that went to $0 along the way. My point is the calls that expire worthless most of the time help to offset the unavoidable losses of risk in the markets that we all experience. It’s a great tool for the long-term investor. The irony for me is that sometime in late 2008 as the markets were crashing I abandoned long-term investing and turned to actively trading, well, after hiding under the covers for about three months that is. I remember hearing something I’ll never forget, it went something like this, “The buy and hold investor is dead, you need to trade these markets if you want to make money investing.” I had a great run trading from 2009-2011 until I blew up my account.

So now I’m at a reset moment for my trading/investing career. The markets are clearly vastly different then when I first invested in 2000. I’m in a different frame of mind personally, different career, literally a much different world. I’ve had great success and failures with differing types of trading activity. I’d like to think I’ve learned a lot along the way and have never been in a better position to profit from these experiences. But the truth is I think luck with timing has been responsible for the larger part of the profits over the years. 

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  1. I remember when I first learned about the covered call back in 2006 when I was interning with a financial advising firm. Although I would say the rest of the internship was kind of a waste of my time. This was the one nugget that made it worth it. As it is what sparked my interest in options. As I believed then and I believe now, if there is only one option strategy a retail investor learns and masters I think the covered call is that strategy.

    Like you I did not fully understand the volatilitly component of the covered call when I first initiated my first one.

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