A (Covered) Call for Caution on the Market

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Last week, HSBC Chairman Stephen Green offered these thoughts to a British banking conference: “We are almost two years into a financial and economic crisis which is still far from over. We cannot even say that we are past the worst or that the way out of the woods is clear.”

Mr. Green’s remarks may prove to be unduly pessimistic, but they caught my attention because it was HSBC that issued some of the earliest warnings about the subprime mortgage crisis when it wrote down the value of its Household International acquisition in what now seems a long-ago 2007. With unemployment rising last week to a grim 9.5%, with California issuing IOUs instead of cash, and with real estate prices still falling, it does indeed seem premature to declare that the financial crisis is at an end.

This newfound sobriety has been reflected lately in the stock market. The Standard & Poor’s 500-stock index was at 946 on June 12; it closed at 881 on Tuesday. A drop of about 7% is hardly cause for alarm, but it is a reminder that the current rally—which some have compared to the rally in 1938—won’t go on indefinitely.

Indeed, historical examples like that give me pause. They’re so aberrational that they’re unlikely to repeat themselves. Few people comparing the recent rally to 1938 mentioned that stocks subsequently dropped and didn’t begin a steady rise again until 1942, when the tide of World War II turned in favor of the Allies.

While I find these historical comparisons interesting, by no means am I predicting anything similar. But there are times when a cautious approach seems warranted, especially after aberrational gains in the market. Earlier this year, I sold “covered calls” on Amazon.com, which is a strategy I often recommend at times like these.

A call is an option to buy a security at a specific price. When selling covered calls, I own the stock but sell the right to buy those shares at a fixed price at some point in the future. If the stock is at or above the price on that date, I either sell the stock at the strike price or buy back the option, depending on my outlook for the stock. If it is below the strike price, I do nothing and simply keep the proceeds of the call-option sale.

In addition to my Amazon moves, I also sold some covered calls on Goldman Sachs as part of my effort to realize gains from the current rally. These call options expire at the end of next week, so the results are nearly in. Both Amazon and Goldman Sachs are stocks I like and have recommended, but nothing rises indefinitely.

Calls Sold

Still, there have been times over the past few months when both stocks seemed to defy gravity. Amazon shares hit nearly $88 on June 5 before dropping to under $76 on Tuesday. I sold the July 80 calls, which means they’ll expire worthless if Amazon trades below $80 on July 18. In that case I’ll keep the shares and sell calls again, this time at a higher strike price. If they’re more than $80, I’ll deliver the shares, keeping the proceeds of the calls I sold plus profit on the shares, which I bought for $60.

I sold the Goldman Sachs calls for a strike price of $125. Given that they’re now trading at more than $142, and were recently even higher, I would have been better off simply holding the shares. But no one has benefit of hindsight. At this rate, it’s likely I’ll deliver the shares for $125, while keeping the proceeds from selling the calls. At the time I sold the calls, I realized that I was capping my potential gains in the event the stock rose significantly above the strike price. I told myself back then that I’d be happy to get $125 for the shares, and I’m still happy now. If I want to continue to own Goldman Sachs shares, I can simply buy more and reduce the price by again selling calls. Even Goldman won’t rise forever.

Curbing Greed

To me, selling covered calls is a good lesson in curbing greed. If a stock on which I’ve sold calls continues to rise, I’ll still make money, even if it’s not quite as much as I would have by simply owning the shares.

If I can’t tolerate earning a good profit just because I could have made even more, then something is wrong.

James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For his past columns, see: www.smartmoney.com/commonsense.