Chasing the Bull

Almost everyone knows about the power of compound interest. The earlier you start investing the better. Kiplinger’s provides three steps to harness the power of compound interest.

1. Start Early
2. Remember that a little bit goes a long way
3. Leave it alone

This is great for those of you who were smart enough to start when they were young. It would be better even still if you were still young. But what about those of us who are slightly older? Did we miss the compound interest train?

Absolutely not! We may just have to rethink or time frame a bit.

If you went to any website that had a savings calculator, Kiplinger for example, you could calculate that if you were to earn 5% a year on an investment of $10,000 you would have approximately $16,289 after ten years. But what would happen if you could make 4% a month? What would your results look like then?

Time Account Value
Start 10,000
Year 1 16,010
Year 2 25,633
Year 3 41,039
Year 4 65,705
Year 5 105,196
Year 6 168,423
Year 7 269,650
Year 8 431,718
Year 9 691,195
Year 10 1,106,626

As you can see, in just over 10 years you would have a sizable portfolio. But is this type of return possible? The experts would tell you no. The reality is that the big money has been using this technique for years and years, continually increasing their net worth.

I have been selling covered calls to generate consistent monthly income for about 6 months now. From my experience, I can tell you that this strategy can work. We have been in a TERRIBLE market lately. If it can work now, it would be magic in a bull market.

I wish I would have known about this in college. My life sure would be different. But, I know about it now and I am actively using this technique. Starting in April, I will post my transactions so that you can follow along.

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Many investors are interested in selling covered calls but really do not know how to begin. This is actually my favorite investing strategy, and as such, I will be allocating a great number of posts to this topic.

Introduction
An option is a financial instrument representing a real contract. It gives the holder the right, but not the obligation, to buy or sell the underlying asset at a certain price up to a certain date (expiration date). Until the expiration date, the holder has the right to buy or sell the underlying stock if the transaction is to his or her benefit. After the expiration date, your option is worthless.

Buying and selling calls and puts is an extremely risky form of investing. These speculators risk their entire investment on a guess of which direction their stocks are heading. Myself, I prefer to sell covered calls which generates consistent monthly income for my portfolio.

The covered call technique involves utilizing “call” options only. Options trade on the stock market just like stocks do. This fact allows us to generate monthly income by selling calls to speculators. Let’s look at a quick example:

Crocs, Inc (CROX)
Current Price - $17.18
Near Month Option - April 2008
Closest Strike Price - $17.50 premium of $1.30

For this example, you would buy 100 shares of CROX at $17.18 and immediately sell 1 April ‘08 $17.50 call for $1.30. My broker, thinkorswim, gives you the ability to do both at the same time. I like this feature because I am only charged one commission of $5, instead of 2 if I did them separately.

The 100 shares would cost you $1,723, but this would be offset slightly by the $130 of income you received from selling the call. Now all you have to do is sit back and wait until the third Friday of April (the expiration date). In this simplistic example, two possible outcomes exist:

1. The stock closes below $17.50 on expiration date and you are not called out. For this transaction, you “earned” a one month return of 7.5%. You earned this money by selling the call to the speculator (who lost all of his money). You now have 100 shares of CROX with no open calls against it. You are free to sell another call or sell the stock.
2. The stock closes above $17.50. In this case, you will get called out of your stock. Don’t worry, it happens automatically and there is nothing you need to do further to make it happen. For this transaction, you earned a one month return of 9.1% [((17.50-17.23)+1.30)/17.23]. Not a bad one month return if you ask me.

Like I said above, this is my favorite investing strategy. It is a powerful way to increase your wealth because you are continually generating cash flow from your stock investments, while simultaneously lowering your cost basis in the stock. It does, however, have its drawbacks. As this post was meant to be an introduction to selling covered calls, I will create a future post describing the challenges of this technique.

Are you selling covered calls? Have you ever wanted to try it? I would love to hear of your experiences selling covered calls.

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