Equity options are products that are used increasingly because they add more flexibility to a portfolio. We gave a brief crash course for options and one of the discussed strategies is covered calls. For many investors, this can add a few percentage points to your net return on an annual basis. The most important thing to remember is to remain disciplined (as most trading strategies would call for) and not get greedy.

How it works

If you own a typical portfolio, you probably own several stocks. In our example, we will look at someone who owns Royal Bank of Canada (RY) stock. As I write, it trades at $55.20CAD. Imagine an investor who owns 1000 shares of RY and does not intend on selling these shares for the moment.

In a covered call strategy, this investor will sell 10 contracts which are currently worth $0.65 (each option contract is equivalent to 100 shares). This will entitle the buyer of the options to buy shares at the strike of the option.

A covered call is basically selling the right to buy your stocks to someone else. We will take a look at APRIL 60 CALLS. This gives the buyer the right to buy RBC stocks at $60 on expiry. And so the investor might have to sell his stock at $60. For this option sold, you receive $0.65 x 10 (contracts) x 100 (options multiplier) = $650

-If RBC is worth $58 at expiry, you will have received the $650 and the options will become worthless to the buyer – you can restart the strategy.
-If RBC is worth $60 at expiry, it will be the exact same thing.
-If RBC is worth $62 at expiry, you will have received $650 and will be forced to sell your shares at 60$.

As you can see, as long as you select a “low strike”, you will end up getting more money than if you only had your stock position.

Even if your shares do climb a lot and you miss out on some of it, you will have profited.

Upside and downside

The upside is that if you select the correct strikes, you will add cash flow to your portfolio. You can do this 3-4 times per year on most positions and make a few thousand bucks.

The main downside is that if the stock goes up by a lot very quickly, you will lose out on some of the rise. For example, if the stock goes up 15% in 3 months, you could end up making only 7-8%… Which is not that bad is it? That is why this is called a covered call. You do not have much risk besides losing out on potential gains, which are extraordinary. I know of many managers who are able to get big returns every month thanks to this method.

Risk involved

One of the main risks of this strategy is becoming greedy. If you want to collect too much, you will trade lower strikes and by doing that you:

-increase your payout (interesting)

-Increase the chances your option will be called (and that you will lose on potential gains) – less interesting.

Overall, this is a very safe strategy because it has so little downside risk. It must be used with caution like any other trading strategy.

Payoff

Here is a graph of the covered call payoff strategy:

Please feel free to ask questions, I know this is not straightforward but used with caution, it can make a big difference to your returns.

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Last post of the year but not the least! This is the big announcement of the final results of our stock contest for 2009!

Quick reminder: on January 1^st, each Blogger had to select 4 stocks (including ETFs) on Canadian or American markets. We have also decided to include dividend in the yield calculation. Each quarter, we followed the rankings and provided commentary on our picks. You can see my 3 quarters here:

Best stock picks 2009 1^st quarter

Best stock picks 2009 2^nd quarter

Best stock picks 2009 3^rd quarter

2009 appeared to be a great year for the stock market but this is not what we were anticipating back in January. We all knew it was meant to come back but we didn’t know when and how strong the stock market would arise from its brutal crash of 2008. I am actually surprised they haven’t given a special name yet to the darkest period  most investors have seen in their lifetimes, any suggestions?

In the end, most of bloggers finished with a positive return and some of them would have made a lot of money with their picks. While 4 stocks is not enough to have a balanced and diversified portfolio, you can build something solid if you use at least 10 stocks,  feel free to use our picks as the foundation  ;-)

So here are my results:

Google (Nasdaq: GOOG):

According to me, this was an easy pick. Google was already on the rise when I picked it in January. Some other techno stocks like Amazon did pretty well too. Google is a strong company and it is demonstrates continuous improvement and innovation. You don’t need any investment services to tell you it’s a good stock to pick!

Com Dev Intl (TSX: CDV):

This was my biggest disappointment of the year. While it was a very promising company with liquid assets and a track record of growth over the past 3 years, Com Dev still flew under the radar of most investors so the stock never picked up. I guess that people were so afraid of investing in 2009 that they would pick small stocks to compliment their portfolios. Make sure to put Com Dev in your track investment apps next year!

Johnson and Johnson (NYMEX: JNJ):

This was my defensive stock pick for 2009 in case we continue to go deeper and deeper. While it didn’t appreciate much, JNJ was more like a safety net in my portfolio than anything else. With its small dividend and its small stock price increase, I am still happy to have it in my 2009 picks

Bank of Nova Scotia (TSX: BNS):

Here again, another easy pick. Canadians banks have always been solid and I knew that it would continue to be the case in 2009. I decided to pick Bank of Nova Scotia since it was the most international of all Canadian Banks. Therefore, I thought that if it was going to be better in another country than Canada in 2009, BNS was surely going to participate. It appeared that any Canadian bank was a good stock pick in 2009 . It also pays a great dividend too!

So overall it is good news since I have finished with at positive yield of  44% and none of my picks were negative! I have finished 4th in the competition. Here are the other results (links to other blogger will update as their post go onlin in the upcoming days):

Stay tuned to see our stock picks for 2010 late tonight and tomorrow morning!

see also:
What does winter look like for Crude? Click Here
Looking for an alternative to gold? Click Here

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Last week, I explained briefly why I personally like doing long/short trades rather than simply buying and being net long. There are advantages to both and I personally do use a long only approach in my retirement accounts. Those trades would also be passive (index) investing. Mike had asked about how I actually did these trades.

1-Stock screener

Each investor probably has more knowledge about a specific sector/industry or region of the world. The good thing about pair trading is that you can trade only those names without huge risk while buying one area in a long portfolio would be more dangerous/risky. Why? Suppose you like technology stocks and are very knowledgeable about companies in the field. You might invest almost all proceeds in a few tech companies. But in a year like 2008, that would have meant big losses. Even choosing the best names in a sector that crashes will generally be a bad scenario.

But when you are trading long/short, if you do pick the right names (both long and short), you will come out with profits even if the whole sector crashes.

Personally, the technology/internet sector is the one that I look at most. I have a table with data about the 20 companies such as earnings, news, stock price, analyst ratings, etc. This helps me to get an idea of what is happening with all 20 companies.

2-Find a trade

When it is time to trade (I generally trade on Monday’s when I have less than 5 trades open), I go through a process where I will look at all the companies according to these criteria:

- No current positions

- Have a clear view on (sometimes companies are in the middle of rumours, about to announce earnings, etc)

Then, I will try to find either the most overvalued or undervalued stock among these ones. Once that is done, I try to pair it up with another one. For example, last week I had discussed the trade on RIM (Research in Motion, maker of the BlackBerry) vs. AAPL (Apple, maker of the iPhone). If I find that Apple is overvalued or undervalued, my first reflex will be to look at the other one to see if a trade is possible. If I find Apple to be overvalued and think about shorting it, I may find that RIM looks undervalued.

It is rarely obvious but after an hour or so, I generally come up with a trade that I am comfortable with, to be executed on the Monday morning opening.

3-Execute

Once I know which stocks I will be buying and selling, I will first look at borrowing. When you sell a stock that you do not own, you will have to borrow the stock. Generally, your broker will be able to take care of it for you but it is still good to confirm that you can short this name. Big names such as Apple and RIM are easy ones to borrow but when you go for smaller names, it could possibly prevent you from making the trade if your broker is unable to borrow the shares.

Once that is done, you would simply set up trade orders for both stocks. I personally do the orders on open (which has its advantages and disadvantages).

4-Evaluate performance

This is the tricky part! When you a buy stock, finding the profit is very easy!

Profit = Number shares x (Price sold – Price Paid)

Return = Profit/Investment

For a long short trade the profit will be:

Profit = Number shares AAPL x (Price sold – Price Paid) + = Number shares RIM x (Price sold – Price Paid) + interest – borrowing costs

Interest will be accumulated because setting up the trade actually requires no money. If you buy 100$ of RIM and sell for 100$ of AAPL, it costs you 0$! Of course, you will need to have money in your account (collateral) but you will earn interest on that money. A downside is that you will be paying borrowing fees on your short position.

You can generally estimate borrowing costs to be offset by the interests earned but that depends on your broker, on which stock you are shorting, etc, etc…

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Yeah I know, I am a bit slow today to post I am actually still a bit sick (thx to the H2N2 (smaller than the H1N1 ).

Since I have received several request to track the TSX 60, their dividend date and yield to date, I have decided to share 2 tables at the beginning of each month. The first one will provide the TSX 60 with dividend date, dividend yield and year to date return for them. The second chart will provide you with all the information you are looking for on the major Canadian ETF’s.

If you want to be aware on when those tables will be published in the future or when I put an update on my Top Dividend Canadian Stocks, you just have to register to my mailing list. We will be providing this info every month!

There is definitely a lot to learn from the 2008 market crunch. But among all the things we should note in our little black book of investing experiences, we should take a page to highlight the psychotic aspect of investors during a Bear Market. Once the panic button has been pushed, everybody runs like chicken with their heads cut off!

Driven by fear, even the traders sold their positions.  They knew that if they lost too much, they wouldn’t have to bother waking up early to come into the office the next morning.

What is happening and why it is happening?

If we take a closer look at the 2008 market “incident”, we see that everything started with the Lehman Brothers’ failure. Trust in banks, brokerage firms and all types of financial institutions was demolished. Once investors have been betrayed (i.e. by a bankruptcy), it is hard to not put all the eggs (good or bad) into the same basket. “banks are all the same” most people said. They were expecting to see all banks seek bankruptcy protection and to see the death of capitalism as we knew it.

This is what I am talking about, THE psychotic aspect of investors . There is nothing that dies faster (besides a fly on your plate at a BBQ ). Most investors were selling banks when it was the perfect time to buy them.

However, as was the case during the tech bubble, you need to be able to make the right stock picks. There are still several banks having financial problems in the States (and I am not even considering  the UK….). However, it doesn’t mean that because an industry is severely affected that cancer has infected the entire body.

Investors had plenty occasions to see that Canadian Banks were not in the same boat.

#1 They declared profits in 2008.

#2 The Bank of Canada didn’t provide much help (some measures were applied but it was minute compared to what happened Globally).

#3 Investors could have looked at how banks in other countries are managed and they would have realized that Canadians banks couldn’t take such risks according to Canadians law.  They also benefitted from an Oligopolistic environment and Government protectionism.

#4 All Canadians banks were fully capitalized and didn’t lack cash. Some of them even issued additional preferred shares to further strengthen their balance sheets and financial ratios but not as a requirement for survival.

#5 Even during the first quarter of 2009, they showed very interesting profits and still their stocks were still undervalued.

Back in 2000, tech stocks, as a category, almost disappeared from the stock market because most of them were walking on thin air. They were selling an idea without a product. They were selling a concept without income. And the worst part, they were issuing shares without mentioning profit forecasts. This is why it crumbled; because this value never existed. However, some techs were strong and well built. Those who survived the crisis did so because they were built and managed differently. Those stocks have risen since then.

This very same phenomenon has happened with banks and other financial institutions. Following this assumption, an interesting buy right now would be Canadian insurance companies as they haven’t come back as strong as banks in term of stock price… What do you think?

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