100% Legal ‘Pyramid Scheme’ Could Produce Double-Digit Income for Years to Come
The covered call strategy is a great way to generate reliable income from your investment capital. Depending on which stocks you trade and the call options you sell against the stock, expected per-year returns are often 20%, 30% or more.
While this strategy produces reliable income, it has one primary drawback: We give up the potential for significant gains by selling others the right to buy shares from us at a particular price. This means that no matter how high our stock trades, we still have an obligation to sell it at a fixed price.
This drawback flies in the face of the well-known trading concept of letting your winners run and cutting losses quickly. In the case of covered calls, we cannot “let our winners run” because once the stock trades above the option’s strike price, there is no added benefit.
But even though our strategy faces this challenge, we can still “let our winners run” by using a pyramid strategy and adding more exposure to our positions as profits increase.
The term “pyramid strategy” refers to building on top of a foundation of profitability, adding more layers of exposure as the stock moves higher. In this case of a covered call position, adding new layers would mean buying new shares of stock and selling new call option contracts as the original position shows a profit.
Before moving further, it is important to understand the benefits as well as the risks for building pyramid exposure. On the plus side, it gives us a chance to generate even more profit from an existing situation. This is important because once we have done the research on a setup, we want to maximize our profit for the time and energy put into figuring out the trade.
On the risk side of the equation, adding pyramid exposure to an existing position increases the chance that an unexpected event could saddle us with a bigger loss than we would take if we were more diversified.
Of course, the covered call approach helps to mitigate this risk because we are selling call options and the income from these contracts can offset at least part of a decline in the stock. However, if a major announcement hits the wires and the stock gaps sharply lower, our losses could be magnified by the fact that we have a much larger position.
Practically speaking, there are a few different decisions we need to make when adding pyramid exposure to covered call positions.
First, we need to determine the size of the new position that we will be entering. As a general rule, I like for the additional layers added to be a bit smaller on the way up. Imagine the shape of a pyramid where each successive layer is a bit narrower and builds on a foundation. This keeps our overall exposure growing while still avoiding accepting too much risk for this one particular stock.
An argument could be made, however, that for covered call positions we actually want to increase our size with each successive part of the position. This is because our original covered call trade will ultimately be exercised (called away) and we will lose that initial exposure. So if we want to build a larger position, one could claim that it is necessary to buy larger portions of stock for each successive purchase. In any event, we will be required to purchase at least another 100 shares of the stock for every additional call option we sell to make sure the position is covered.
A second consideration is the strike price of the next set of calls that we will sell. If we are already building profits on our original trade, then it is safe to assume that the stock price remains stable at the very least, and is likely to be trading higher.
If the underlying stock has a well-established bull trend, it may serve us best to sell a call contract with a higher strike price for the additional shares of stock that we buy. If we sell out-of-the-money calls, we will also be able to benefit from at least a small increase in the stock in addition to the premium we receive from selling the call contract. On the other hand, if the stock is simply holding steady, it may make sense to sell a call option with the same strike price and simply collect more premium as time passes.
A third consideration is the expiration date of the additional call contracts. Since our new pyramid trade will naturally occur after our first position has been in play for some time, it often makes sense to sell calls that expire a bit farther down the road. This allows us to capture more time premium, giving us more income, and also allows us to stay involved with the trade for a longer period of time. This is attractive if the stock is continuing to hold up well.
Ultimately, for the very best covered call candidates, you can continue to pyramid your exposure for months and even years at a time, allowing the first set of calls to expire or be exercised, and then steadily adding to the position for as long as it continues to work.
Note: Using a pyramid strategy to sell covered calls is a great way to create income. Lately, my colleague Amber Hestla has been showing readers how steal thousands of dollars from Wall Street using a similar strategy. It’s called the “Hestla Heist.” In the past two years, her readers have executed dozens of these quick heists — sometimes to the tune of $1,200 or more.
If you’re interested in learning more about the “Hestla Heist” and making some extra money today, I urge you to check out her presentation here.