Don’t Rely on Screeners for Covered Calls

Back in the late 1990s, I discovered the usefulness of options. Some of you might remember a crazy little momentum stock and company named Iomega. It was the first stock to create a real mania in the modern market, where it seemingly soared day after day, split every other week and just kept going higher. The idea of removable storage (Iomega’s Zip and Jaz drives) with a lot of capacity was taking the computer nerd world by storm.

As with all momentum stocks, the momentum dissipated. The stock cratered and languished (the company is now part of tech giant EMC [NYSE:EMC]). As a newbie to the market, I had gotten caught in the hype, and held far too many shares at an average price of $12 or so. The stock was in the high $9s.

So I began selling covered calls every single month at the $10 strike price, and collected the premium. By some miracle, the stock never got called away, and after a year, I finally had collected enough premiums to bring my effective average price down to $9.50. Then I sold the underlying and broke even on the whole deal.

Covered calls! Woo hoo!

Cut to a few years later. I salivate at the prospect of selling a covered call one month out on a $150 stock for $22! That’s a $2,200 premium! I rubbed my greedy little hands together. Until the stock cratered over the next month into the high $90s and kept going down from there. Somewhere along the line, I think there was a 1 for 100 reverse split. Today, ICG Group (NASDAQ:ICGE) is around $10.

Covered calls! Boo hoo!

I found both of these deals using covered calls screeners. Today, there are vastly more of them than there used to be. Some are subscription, some are free. But in all cases, you must be careful which stocks to use covered calls on.

As I learned from the ICG case, you can’t just bite off a huge premium and buy your mai-tai poolside. That premium is high for a reason — lots of volatility in the underlying stock. Volatility means there’s some uncertainty surrounding the company. Uncertainty translates to increased risk.

Take a look at this options screener, which I am neither endorsing nor condemning. I’m just using it as an example. As I wrote this, ProShares UltraShort DJ-UBS Natural Gas (NYSE:KOLD) was listed at this site as trading at $28.52, with the September 29 Calls at $3.70. That’s an incredible return of almost 15%. If you’re just going for premium, without understanding that this is an option tied to a 3x leveraged short position on natural gas, you could get seriously burned … even if the natural gas isn’t set on fire.

My preferred strategies for covered calls are as follows:

1) Use them to generate income against very long-term positions. I may sell calls against half a position to squeeze some extra juice out of a holding.

2) Use them to generate income on stalwart stocks. These are stocks that are core positions in your portfolio that are world-class brand names that will never go out of business. This is stuff like ExxonMobil (NYSE:XOM) or Coca-Cola (NYSE:KO). You can generate 2% – 2.5% returns monthly with this strategy. If the stock is called away, repurchase it and sell the calls again. If not, just sell the calls on the stock next month. The idea is that you will never get stuck with a loss because the company will eventually recover its price over the long term.

3) Use them when holding a value stock. In this case, you can go for the more aggressive premiums because your analysis shows that the stock itself is vastly undervalued. In theory, you can collect these nice premiums because downside risk is limited. I’ve mentioned First Cash Financial Services (NASDAQ:FCFS) and EZCORP (NASDAQ:EZPW) as two selections that I have done this with over several years.

Lawrence Meyers owns shares of EZCORP. He does not presently hold any positions in any other securities mentioned. He had sold covered calls against a position in First Cash, which were assigned on Aug. 17.

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