A Tribute to Coach Wooden

Sunday, October 14, 2007 is the 97th birthday of Coach John Wooden. Coach has had a great influence on me despite the fact that I have never played basketball on his team or even met him face-to-face. Sure, I’m a basketball fan and his coaching accomplishments are legendary – in fact many consider him as the best coach of all time. But his greater influence to me is as a premier role model in his beliefs and personal character.

During the summer after my sophomore year in high school, I attended the week-long Pocono Mountain Basketball Camp in Pennsylvania. The highlight of that experience was the appearance of Coach Wooden after dinner Friday night and the talk he gave to us on his ‘Pyramid of Success’. He has long defined success by saying: “Success is peace of mind which is a direct result of self-satisfaction in knowing you made the effort to do the best of which you are capable." He explained the pyramid to us in some detail that evening; and yes, he described how it related to playing basketball. But the primary focus of the pyramid really had little to do with basketball, but everything to do with how to live our lives. Even to this day, I have a framed ‘Pyramid of Success’ as signed by ‘John Wooden’ as the sole item hanging in front of me above my computer desk.

McDonald’s has developed a website dedicated to Coach Wooden as a tribute to him. I sincerely hope you will spend 15 or 20 minutes there. I especially recommend you spend time in the links for The Pyramid of Success and also Favorite Maxims (especially his Seven Point Creed). Enjoy:
Coach Wooden link

Since this site is devoted to covered calls investing, I’ve developed the following as a personal tribute to Coach:

Stock Selection is the foundation.The diversification triumverate of asset allocation, sector diversification, and position sizing is at the central core. Covered call position selection is at the pinnacle. These components act together to enable success for the covered calls investor.



Making the effort to do the best of which I am capable,

Regards and Godspeed

Reminder: Begin Writing Your Monthly Themes

A prior post (Investing Themes link) presented a case to encourage every covered call investor to develop a written list of his/her investing ‘themes’ that would help to provide overall guidance in making stock selection decisions, and to do so during the week prior to options expiration each month. Therefore, the time to begin with a first draft of your current investing themes is NOW. Don’t expect your first draft to be a finely crafted list. Remember, it’s only a first draft (a rough draft) of those investing themes that you want to emphasize for your portfolio holdings in the near-term future. If you write your first draft sometime during this weekend (Note: you might want to plan to write your first draft during the weekend prior to options expiration Friday every month), then you can spend a few minutes from time to time during the remainder of this upcoming week thinking about, modifying, and fine tuning your themes.

To assist you in initiating the process of writing down your investing themes monthly, the current themes of the Covered Calls Advisor are presented below. You are welcome to use them as a guideline for developing your own themes. But please, whatever your themes are, write them down! Trust me – don’t take a shortcut here and simply think about your themes. Again, write them down! As the months go by, you’ll be pleasantly surprised at how much the process of committing your ideas to paper will help you to clarify your thinking when it comes to making your stock selection decisions.

The Covered Calls Advisors current investing themes are:
1. Sector Weightings:
· Overweight – Health Care; Industrials; Technology
· Marketweight – Materials; Energy; Consumer Staples; Telecom
· Underweight – Consumer Discretionary; Finance; Utilities
2. Emphasize large-cap companies.
3. Emphasize domestic companies that have a large international exposure.
4. Overweight international equities – especially big Europe (i.e. United Kingdom, Germany and France); South Korea; and Taiwan.
5. Emphasize companies whose exposure to high energy and other commodity costs is minimal.
6. Mitigate risk caused by the slowdown in the U.S. economy. Identify companies with more defensively-oriented characteristics (such as health care) and that are less dependent on increases in consumer spending.

The time is now! Get that pen and paper (or turn on your Microsoft Word program) and begin to write your first draft of your own current investing themes.

Regards and Godspeed

Keep or Sell?

Expiration Friday for October is now exactly one week away. Let’s consider the following question: How should we decide which stocks currently owned in our covered calls portfolio should be kept and which ones should be sold? This article describes the decision-making process used by the Covered Calls Advisor to answer this question.

While the decision to sell an existing underlying stock can of course be made at any time, the overwhelming majority of the keep or sell decisions made by us covered call investors are normally made near the monthly options expiration dates. The easiest approach to the keep or sell decision faced by us covered call investors as an expiration Friday approaches is to simply do nothing. And unfortunately, since it is the easiest approach, it is too often the approach used by many covered call investors. With this approach, the following will automatically occur:
1. Almost all in-the-money (ITM) positions will be called away (a.k.a. ‘assigned’ or ‘exercised’) and the underlying stock will be sold for the strike price value; and
2. For all out-of-the-money (OTM) positions, the options will expire worthless and the underlying stock is retained in the portfolio.

This do-nothing approach is absolutely NOT the technique recommended by this advisor. It definitely flies in the face of good common sense when you think about it, since the end result of this do-nothing approach is that those stocks are sold which have actually been the strongest performers in the portfolio (the winners if you will); and those stocks that have been the weakest performers (i.e. the losers) are the ones that are retained. This is exactly the opposite of what we would normally be inclined to do if we simply owned the stocks and were not facing an imminent options expiration date.

Since the result of this do-nothing approach is inherently counterintuitive and clearly undesirable, then what does constitute a desirable approach? First, plan to evaluate each and every stock in the portfolio to make an assessment of whether to keep or sell that stock, based on an objective set of pre-defined criteria. For the Covered Calls Advisor, the keep or sell decision-making process is as follows:
1. During the week prior to expiration each month, make a list of all covered call stocks that have options written against them for that particular month.
2. Plan to sell (either on expiration Friday or early the following Monday) those stocks for which any one of the following criteria is met:
· The stock rating as provided by either of the two stock advisory services you follow has been reduced below a ‘buy’ rating; or
· The consensus analysts’ future earnings estimates (see Reuters Research) for the company have been reduced since the stock was initially purchased; or
· There is an earnings release scheduled between this month’s expiration date and prior to next month’s options expiration date; or
· The annualized return if unchanged % (ARIU) for establishing next month’s covered call position does not meet or exceed a 25%+ threshold.
3. Process any transactions necessary in order to: (a) keep those stocks for writing additional covered calls for the next month that meet all criteria listed in #2 above; and (b) sell those stocks that fail to meet any one of the criteria listed in #2 above.

The requirements listed in #2 above are very restrictive – so much so that it has been this advisor’s experience that it is not uncommon for only 20% to 25% of stocks to be retained from one expiration month to the next. But don’t be concerned about the relatively high turnover – over a period of time you’ll see that it is actually quite preferable to other alternatives.

So how does this approach apply to the eleven positions currently in the Covered Calls Advisor Portfolio? As of right now, only two of these stocks (BMC and TRV) have earnings releases scheduled for the period between October expiration (10/22/07) and November expiration (11/17/07) and so they will definitely be eliminated from the ongoing CCAP. However, all eleven positions will be re-evaluated next Friday (on the expiration date itself) to make the final keep or sell decision based on using all four of the analysis criteria for each stock owned.

Regards and Godspeed

Using ONLY Annualized Return on Investment %

Let me state my position on this topic as directly and forcefully as I can: "When evaluating the return on any potential investment (and that definitely includes all potential covered call investments), always calculate the annualized ROI %."
For covered call investments, the formula for calculating the annualized return on investment if the stock price is unchanged at expiration compared with its price when the covered call position was established (annualized return if unchanged; or ARIU) is:
ARIU= ($ option premium/$ original investment)*(365 days/# days until expiration)*100
For example, American Express(AXP) closed today at $61.89. If we purchased 100 shares at $61.89 and sold 1 NOV'07 62.5 call at its bid price of $2.00, the corresponding annualized ROI % calculation (excluding commissions) would be:
ARIU = ($200/$6189)*(365/37)*100 = 31.9%

The importance of always calculating the annualized ROI % cannot be over-emphasized. In short, it is the only way an investment return should be considered in relation to its potential as an investment. In addition to its usefulness in evaluating potential positions, it is also the method by which any investment return result should be measured; both when an existing position is finished as well as for some specified duration of time, such as at the end of each month. Some of you are now thinking 'Yes, of course. Why does he even need to spend the time to emphasize such a fundamental principle?' -- and if you already use this approach, then good for you. However, this advisor has simply seen far to many instances when financial analysts and investors have used other measures (i.e. different than annualized ROI %) to analyze investment returns; and erroneous measures often and readily lead to erroneous conclusions regarding which covered call investment alternative provides the highest return.

Two examples of incorrect, but frequently used approaches by investors in looking at the relative attractiveness of the returns on potential investments are: '$ returns' and '% absolute returns'. Unfortunately, many investors focus on one or both of these measures while totally neglecting the preferred measure of annualized ROI %. The chart below presents these three return measures for evaluating AXP covered call choices for the 62.5 strike price and for four different expiration months (Oct'07, Nov'07, Jan'08, and Apr'08).



In looking at the chart, which of the four expiration months provides the highest return? If you said "October 07", then congratulations!
But let's explore this a little further. As an example, if Investor A is primarily interested simply in $s returned, then the $490 for the Apr'08 covered call seems like the best alternative. If Investor B is somewhat more savvy than Investor A and calculates a ROI %, but calculates simply the absolute ROI % ($ option premium)/$ original investment), then the 7.9% return for the Apr'08 covered call would again seem to be the best choice.

The misguided approach used by both Investor A and Investor B will invariably lead them to the wrong selection if one of their primary objectives is to maximize the return on their investment. The Oct'07 covered call annualized return of 49.1% actually provides the highest return opportunity of the four expiration months analyzed in this example. The essential fact is that always calculating the annualized ROI % is the best method for providing an apples-to-apples comparison of investment alternatives with varying time horizons. I feel fortunate for having gained an appreciation for this approach many years ago from an excellent Engineering Economics professor in a course taken during my sophomore year at N.C. State -- it has benefited me greatly throughout both my professional and investing careers.

So, do you agree that you should always calculate the annualized ROI %?
I know, some of you are now saying "yeah, I agree with that; but a complete analysis of a potential covered call position must consider more than simply which alternative will provide the highest annualized ROI %!"
My response to that is "Yes. Absolutely! But analyzing the potential return on any investment is critically important (Job #1 so to speak); so using the correct analytical approach is key."
You might add: "What about investing safety, such as how much downside protection I should obtain? And don't the longer-term expirations usually provide more downside protection?"
My answer to that would be "sometimes yes and sometimes no".
But that's a topic for a later date.

Regards and Godspeed