Tuesday, June 26, 2012
WHY I LIKE DITM INVESTING - LET ME COUNT THE WAYS!
The uglier the stock market gets, the more I like the Deep-In-The-Money Covered Call strategy. It has to be the #1 strategy for a FLAT or DOWN market.
Here are some reasons:
* When you buy a stock that pays a 4% dividend and at the same time (Buy/Write) sell a covered call 10% below the buy price, you are in a sense buying it at a discount! For example: Buy XYZ at $50 on July 1 and sell a call option to deliver the shares at $45 in January 2013. The call should be priced around $6 ($5 for the amount that you are losing by selling it lower - Intrinsic Value; plus $1 (Extrinsic Value) for allowing the call Buyer to take the stock at $45 no matter what the price of the stock is in January). XYZ pays a dividend of 4% per year, or $.50 each quarter, with the first ex--dividend date within a day or two of your purchase.
Since you, in essence, paid $45/share or $4500 for the stock, your dividend percentage is 4.44%, not 4%!
* Much like a CD or Bond, you know pretty much what your return is going to be - with the stock's Appreciation no longer a factor - so it can go up to $55 or down to $46 and your return is the same. With all this tremendous volatility in the markets due to economic conditions and High Frequency Trading by computers (70% of market Volume), the $45 is a Safety Net allowing you to sleep at night while other owners worry what the next day will bring, and whether they should Hold or Fold.
* If the stock rises, so does your margin of safety - and the stock may get "called" away early, increasing your % return by compressing the time. The combination of dividends and call "premiums" historically in extensive testing has steadily averaged an "annualized" 10% - fully invested and extended for 12 months at the same ROR -rate of return. You will lose any upside price of XYZ (rare these days), but still earn what has been the historical average: 10% for over 100 years. Probably less, since the last decade has seen zero return, besides dividends.
* If the stock remains the same- $50- ( winds up the same at expiration - January), you can just sell the next call - 6 months hence: July 2013 at $45 strike. Minimal monitoring.
* If XYZ works its way down to $45 by January - better yet! The call option expires worthless (no need for anyone to exercise it and take away your stock at $45 when they can buy it for $45). So you can "step down" selling the next call option at $40, making the same dividend - $2.00- now earn 5% instead of the previous 4.44% or 4%. Additionally, when a stock drops the options "Volatility/Price" rises - witness the VIX in a down market.
* If the stock actually goes below $45 and stays there in January, you can write/sell the same covered call in the normal covered call fashion - above the stock price- again, at the $45 level, and wait for the stock to rebound - which it usually does. You are less likely to get "shaken" out just as the stock bottoms out.
* If the XYZ and/or the market goes into a BEAR phase - historically 1 or 2 times per decade since 1900- it is possible to lose some money, but much less than someone just holding stocks or an Index fund. Having the Safety Net gives one time of warning to hedge any or all positions - by using inverse ETFs, put spreads, etc.
* Laddering. Just like Bond portfolios, it is advisable to spread out ex-dividend dates, pay dates, and option expiry dates. It not only spreads the Risk by closing out mature positions cheaply, but provides a steady income each week/month from quarterly dividends and call-selling.
* Finally, with experience your returns should even get better. If you find a stock that you like - dividend over 3%; calls with "juicy" extrinsic premium, and a stable trading range along with good fundamentals and market/sector outlook - but the ex-dividend is still weeks away- you can sell a put or put spread to take on the stock. This not only provides good income, but alerts you to the upcoming ex-dividend date. One idea that did not work out as well was to DITM stocks that only pay Annual dividends! If the stock drops, you cannot wait for the next (quarterly) dividend to bail you out ( next year?), plus most are foreign stocks that may have their own taxing authority.
Posted by DITMcalls at 12:18 PM