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On paper the strategy below offers little downside and excellent upside. However, if the commodities ‘bubble’ goes pop damage control must be immediate in order to be effective.
Although not to be included in the Wish List (the list tracks long equity positions only), I have entered into a covered up position on Lundin Mining Corp., a company researched but not selected in this years report. The math on the position is as follows:
It is often said that one of the problems with writing covered calls is missed opportunities (i.e. under the above strategy if LMC’s stock price soars to say $15/share your shares are called/sold at only $10/share). While this viewpoint is definitely valid under many less beefy scenarios, the potential for a 19.7% return in 6-months can hardly be called a ‘missed opportunity’.
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While the best outcome for the position is 19.7% before taxes and commissions, an acceptable return can still be had if LMC shares slip down to the $8.40/share level. Conversely, the clear danger with the above strategy is that LMC’s stock price declines below the ‘acceptable’ return level and/or below the break even point of $8.10/share. To avoid this outcome the investor has a couple of choices: 1) Eat the loss if LMC shares are declining by closing out the entire position, or 2) Sell the stock if shares move below $8.40 and hope that the calls expire worthless.
Needless to say, the reason Todd and I do not include covered calls in the Wish List is because no matter how well the strategy is discussed beforehand different methods of hedging and/or closing out part or all of the position can arise before expiration. For example, I happen to think that if LMC shares are hitting new 52-week lows below $8.46/share that this would be in response to a serious decline in base metal prices, and that under such a scenario selling the shares and carrying the calls naked would not be that risky. But alas, this outlook could quickly change…
In short, please be aware that writing covered calls as an investment strategy can be very dangerous. LMC is not being selected as a stand alone investment at this time.
Disclosure: Brady Willett has entered into a covered call strategy on LMC. |
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