Covered Calls and LEAPS -- A Wealth Option: A Guide for Generating Extraordinary Monthly Income

By Joseph R. Hooper, Aaron R. Zalewski and Robert Kiyosaki

In this one-of-a-kind "how-to" guide, Joseph Hooper and Aaron Zalewski provide step-by-step instructions for generating large monthly cash returns from almost any stock investment—while at the same time decreasing the risk of stock ownership. Filled with in-depth insights and proven techniques, this book is the definitive, rule-based guide to covered calls and calendar LEAPS spreads.

• Language: English
• Publisher: Wiley
• Release date: Dec 15, 2010
• ISBN: 9781118038949

Book preview

001

Table of Contents

Title Page

Copyright Page

Foreword

Preface

OPTIONS ARE NOT JUST A HIGH RISK/HIGH RETURN INSTRUMENT

CHAPTER 1 - An Introduction to Options

MARKET BASICS

OPTIONS BASICS

PART I - Covered Calls

CHAPTER 2 - An Introduction to Covered Calls

OPTION SELLERS/WRITERS

COVERED CALLS: THE RIGHT MIND-SET

CHAPTER 3 - Entering New Covered Calls Positions

SOME BASICS

THE RULES FOR ENTERING NEW COVERED CALL POSITIONS IN THE U.S. MARKET

USING THE CSE SCREENER TO SELECT U.S. COVERED CALLS

USING PRICE CHARTS

INVESTING IN NON-U.S. MARKETS

CHAPTER 4 - Management Rules

CLOSING POSITIONS ON THE DELTA EFFECT

THE MID-MONTH RULE

SECONDARY CALL SALES

THE TETHERED SLINGSHOT FOR INCOME AND THE SELLING HIGH RULE

SELLING CALLS ON EXISTING STOCK HOLDINGS

IMPLEMENTING A COVERED CALL STRATEGY USING OTHER STOCK SELECTION METHODS

CHAPTER 5 - Defensive Techniques

BASIC DEFENSIVE TECHNIQUES

ADVANCED DEFENSIVE TECHNIQUES

PART II - Calendar LEAPS Spreads

CHAPTER 6 - An Introduction to Calendar LEAPS Spreads

ADVANTAGES OF THE LEAPS TECHNIQUE

USING LEAPS FOR COVER

CHAPTER 7 - Entering New LEAPS Positions

SOME BASICS

THE RULES FOR ENTERING NEW LEAPS POSITIONS

USING THE CSE SCREENER TO FILTER LEAPS INVESTMENTS

USING PRICE CHARTS WITH THE LEAPS TECHNIQUE

THE BUYING LOW RULE FOR LEAPS

CONSTRUCTING A LEAPS POSITION

CHAPTER 8 - Management Rules

THE 10c AND 5% BUYBACK RULES

THE DELTA LOW BRIDGE

SECONDARY CALL SALES: MANAGING LEAPS THAT HAVE NOT SOLD FOR A PROFIT

CHAPTER 9 - Defensive Techniques

SURROGATE LEAPS REPLACEMENT

AVERAGING DOWN

REPOSITIONING A LEAPS

ROLLING OUT

CONCLUSION

APPENDIX A - Quick Reference Guide

APPENDIX B - Foreign Exchange Risk

APPENDIX C - Brokerages and Order Types

APPENDIX D - Using ETFs and HOLDRs for Diversification

APPENDIX E - Compound Stock Earnings Support Services

Glossary

Index

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Copyright © 2007 by Compound Stock Earnings Seminars, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Hooper, Joseph, 1943-

Covered calls—A wealth option : a guide for generating extraordinary monthly income / Joseph Hooper And Aaron Zalewski. p. cm.

Includes bibliographical references and index.

ISBN-13 978-0-470-04470-4 (cloth/dvd : alk. paper) ISBN-10 0-470-04470-5 (cloth/dvd : alk. paper)

1. Options (Finance) 2. Stock options. I. Zalewski, Aaron, 1980- II. Title. III. Title: Covered calls.

HG6024.A3H66 2006

332.63’2283—dc22 2006015461

Foreword

Brilliant book. Anyone who has read any of my work knows that I believe buying, holding, and praying is not an optimal financial strategy. Joseph Hooper and Aaron Zalewski have done an excellent job making a complex subject simple enough for someone like me to understand.

As most of us know, investors invest for two basic things: capital gains and cash flow. Most people invest for capital gains, which is simply buying something and hoping the price goes up. Investing for cash flow is investing for a steady stream of income. Of the two, investing for cash flow requires the most skill. Anyone can deceive themselves by thinking, The price will go up in the future. Or anyone can be suckered into a sales pitch that goes: Prices have gone up over the past five years . . . so you better buy now.

The reason I love this book is because the authors have made investing for cash flow simple. I like the analogy in their Preface of planting trees and growing a forest to be cut down as an example of investing for capital gains versus planting fruit trees to harvest and replenish on a regular basis as the example of investing for cash flow. Obviously, the more savvy investors invest for both capital gains and cash flow. They want a forest and the fruit. They want money today and tomorrow.

Regardless, even if you never plan on investing in stocks or covered calls, this is an excellent book for anyone who wants to look into the mind of a professional investor. You see, the investment strategy discussed in this book does not apply only to stocks. This investment strategy works for real estate as well. Rarely do I buy a stock or piece of real estate without first knowing that I will receive cash flow and capital gains. In other words, this book is not about an asset class but more about a class of investor that likes to win, not gamble.

ROBERT KIYOSAKI

Author of Rich Dad, Poor Dad

Preface

One can think of the accumulation of a stock portfolio through time as the cultivation of a forest full of trees. Traditional Street mentality encourages investors to plant trees throughout their working lives and rely on appreciating markets to grow the forest over the long term.

Once our working lives are finished and active income ceases, the Street then encourages investors to begin cutting down the forest to provide income in retirement. The hope is that the forest has grown large enough over time to withstand the depletion in retirement. In our experience, this level of growth is a rarity for the average American.

What the Street has overlooked is that simple and very conservative cultivation can transform the forest into an orchard of fruit-bearing trees. Fruit-bearing trees generate cash income on a monthly basis. For investors who want to grow their assets, rather than eating the fruit each month, the fruit can be left to fall on fertile soils to grow more trees and thus to compound the growth of the forest through time. For investors who are in retirement, the fruit can be picked each month as cash income for living expenses—without liquidating stocks in the portfolio and destroying the forest that they depend on to live.

Correct application of the covered call technique is the vehicle by which stocks are converted to cash flow generating assets.

OPTIONS ARE NOT JUST A HIGH RISK/HIGH RETURN INSTRUMENT

Options are without doubt the most misunderstood, misrepresented, and poorly implemented financial tool in the world. When asked about options, most people (including those in the know like financial planners, stockbrokers, and accountants) will tell you that they’re high-risk, high-return instruments.

It is astonishing that even those who are financially educated seem unaware that options can be used to minimize or even eliminate risk in a stock portfolio. In fact, options were originally not devised for use as a speculative instrument. They were originally used in the agricultural industry to reduce risk by locking in future sales prices before harvest. Regardless of this original intent, options maintain the label of high risk, high return.

The high-risk, high-return label derives its origins from the speculative use of options. Speculators use options to bet on the direction of the markets for the potential of very high returns. However, with these high returns come very high risk, and the vast majority of speculators fail over the long term. If you ever attempt to speculate with options, there is a very high chance that you, too, will be unsuccessful over the long term.

What evidence do we have that the vast majority of speculators fail over the long term? Well, if just 10 percent of the world’s speculators were making regular 50-100 percent returns per trade over the long term (as is the goal of a speculator), then the world would be full of multi, multimillionaires who made overnight fortunes trading options. Clearly, this is not the reality. However, this get-rich-quick ideal continues to be perpetuated by the endless hope of investors seeking a quick and easy solution to their financial woes.

Options markets are a zero-sum game. Someone wins only when someone else loses. If most speculators lose in the long run, who are the winners? Apart from the market makers and the small portion of speculators who win over the long term, money flows each and every month into the hands of option writers. Option writers are the people who are selling option contracts to the speculators.

What we want to teach you has nothing to do with the risky practice of speculating with options—this is not high-risk, high-return trading. In fact, covered calls are almost the complete opposite. In this book we show you a way to use options to make consistent, steady profits that you can rely on to pay your mortgage and put food on your table or to compound your investment capital through time into significant accumulations of wealth.

JOSEPH HOOPER

AARON ZALEWSKI

CHAPTER 1

An Introduction to Options

MARKET BASICS

This section is written specifically for the stock market novice. It is aimed at those who have never bought a stock before or those who have very little understanding of the most basic functions of stock and option markets.

What Is the Stock Market?

From the perspective of a private investor, the stock market provides a venue for the buying and selling of stock of publicly listed companies. If you want to buy fruit, you go to the fruit market. If you want to buy stocks, you buy them through the stock market—it is as simple as that. Other common terms for the stock market include:

• Share market

• Equity market

• Simply the market

From the perspective of a company, listing on the stock market provides access to a large amount of investment capital that would not otherwise be available to an unlisted company. The market provides companies with the ability to seek investment funds from retail investors as well as institutional investors (fund managers, banks, etc.) who invest on behalf of others. Access to this public market capital enables a listed company to significantly extend its potential funding base upon which it can expand and grow its business in the future.

What Is a Share?

A share represents a portion of ownership of a company. Public companies are very large and, in most instances, are not owned by just one person or entity. Many thousands of different people or entities own stock in large listed public companies.

A share literally entitles its owner to a portion of a company’s earnings (as dividends) and a claim on the company’s assets in the event of bankruptcy (priority given to creditors). Through the election of company directors, stockowners are also entitled to participate in deciding the future direction of the company.

Most adults are already stockowners. Some of these stockowners are active investors who buy and sell stocks based on their own research or on the advice of their peers or professional advisers such as a stockbroker. Other stockowners gain exposure to the stock market through mutual funds where money is pooled and invested by a professional fund manager.

How Are Stocks Bought and Sold on the Stock Market?

Think of the stock market like a fruit market. Let’s assume you want to buy 10 bananas. You need to go to the fruit market and see who is selling bananas and at what price. Store owners are entitled to sell their bananas at whatever price they see fit. Obviously they don’t want to make the price too high or their fruit won’t sell, or too low because then they are not making as much money as they could.

You find three different stores selling bananas:

Asking Price, 10 Bananas

You obviously want to buy your bananas as cheaply as possible. If you think $1.40 is reasonable, you might simply buy them from store 1 at that price. If you are only prepared to pay $1.35, then you might bid to buy them at $1.35. The manager at store 1 may agree to this price as it’s not far away from his asking price. If you both agree on a price, the bananas will sell.

Buying stocks on the stock market works exactly the same way! Let’s assume you want to buy 100 shares of General Electric (GE). You look up the price at the stock market by calling your stockbroker (or going to your broker’s online site). You are presented with the market for GE stock. It looks Table 1.1.

TABLE 1.1 The Market for GE Stock

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If you want to buy 100 shares, you need to buy them by reaching an agreement on price from someone who wants to sell them. The sellers put into the market how many shares they want to sell and at what price (the ask price). You obviously want to buy the stock as cheaply as possible, so the seller asking the lowest price is always at the top of the list. He or she is offering 5,000 shares for sale at a price of $25.20.

You now have two options:

1. If you think $25.20 is a reasonable price, you can simply put in a bid to buy 100 shares of GE at $25.20 and your order will be filled.

2. If you think $25.20 is not a reasonable price, you can put in a bid for less.

Let’s assume you think $25.10 is a reasonable price. You enter this bid price into the market and the market will then look like Table 1.2. Your bid is now at the top of the column because you are the current highest bidder. If the seller at $25.20 (or any other seller) thinks that $25.10 is a reasonable price, he or she may change the order to $25.10 and the stock will trade. Or a new seller might come into the market enticed by your bid of $25.10 and your stock may trade.

What Is a Stock Code or Symbol?

All stocks that trade on public markets are represented by an individual stock code or symbol. No two stocks have the same stock code.

TABLE 1.2 Entering a Bid into the Market

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While these terms can be used interchangeably, in the United States, the term symbol is used. U.S. stock symbols consist of one letter to five letters. For example, Citigroup is represented by the symbol C, Wal-Mart is represented by the symbol WMT, and Shire Pharmaceuticals is represented by the symbol SHPGY.

Option contracts in the United States are also represented by symbols/ tickers, which are generally five letters long. As with stocks, no two option contracts have the same symbol.

What Makes Stock Prices Go Up and Down?

Many factors influence the price at which a company’s stock trades, the most important factor being a company’s future earnings. Various fundamental factors combine to influence a company’s future earnings. You will become very familiar with fundamental factors as they are of particular interest to financial analysts and also gain significant exposure in the financial press. Common fundamental factors that affect the future earnings potential of a company include:

• Company-related issues such as increases or decreases in sales, increases or decreases in the cost of doing business, and changes in asset position, management team, business model, or perceived business risk.

• Industry-related issues such as the financial performance of competitors or introduction of significant legislation.

• Economic-related issues such as the economic growth rate of economies in which the business operates, currency fluctuations, and interest rate or inflation rate changes.

If a fundamental factor changes and causes the market to think that a company’s future earnings will be higher (lower) than previously expected, the stock price will adjust upward (downward) accordingly.

Other influences on stock prices that you should be aware of are technical factors. Technical analysis is the study of stock price charts through time. There are many investors and traders in the financial markets who make buy and sell decisions based solely on technical analysis because they believe that all fundamental factors are represented in the price charts they analyze.

We discuss both fundamental and technical factors in more depth later in this book.

What Is a Stockbroker?

Stockbrokers provide access to the stock market by entering buy and sell orders into the market on behalf of investors. Stockbrokers also hold accounts on behalf of investors where electronic records of stocks, options, and cash held are kept.

A brokerage account is just like a bank account except it holds stocks and options as well as cash. To set up a brokerage account, contact a broker (via phone or online), fill out the paperwork, and deposit money into your account. For the type of investing you are going to be doing, it is best to use a discount broker with the lowest possible transaction costs and fast executions.

Do not use a boutique broker (one who provides advice), even if you currently use one. They are expensive and, from