Covered Calls

What’s your experience with covered calls? Are they worth doing in this market?

Kenneth

What you want is to find a stock that will be relatively stable, and to sell the calls at the highest VIX points possible (like after some of these repeated 500-point rallies and collapses). Decide whether you want to keep the stock or not, and that’ll help you decide whether to sell the calls at-the-money or deep-in-the-money or way out-of-the-money (ATM, ITM, OTM).

Tyson was a good one a couple of weeks ago; the price was around $5 and the calls were selling for $1.6 or so. Thus, even a 33% collapse in the stock price was hedged. Of course, now it’s at $6.7, so it would’ve been a slight money loss to do that transaction, but who would’ve guessed that even a week ago? And tomorrow it could crash again. Hell, probably will.

The biggest problem in this market is that selling “covered” calls requires that you OWN THE STOCK, and the market is still overvalued. The more I look at it, the more I’m wishing I’d placed my bet a lot lower than 8300 for next year’s Dow price. If you’re feeling particularly suicidal, try selling uncovered calls after major rallies instead.

The problem here is that it assumes the ‘trader’ is better than most, or has an edge, identifying stocks that will trade flat or rise. If he has that edge, why doesn’t he have that edge for identifying stocks that will go up? Or go down? The strategy presumes a fallacy. And market expectations of risk will be embedded in option prices anyway, so the ‘trader’ must know something the market doesn’t. Covered calls work, until they don’t. And when they don’t all the previous profits disappear in spades.

I could rant but … truth is most people have to learn this the hard way.

Have fun.

I think you may not fully understand what is meant by selling covered calls. They limit the upside, but they also hedge slightly against the downside. If the stock remains stable, you get a monthly chunk of spare change off each transaction.

All the “edge” stuff you wrote applies just as much to ANY form of investing, whether going long, short, playing with options, or putting money into a Somali pirate ring.

BTW, the strategy of selling covered calls has limited risk. It’s not like selling UNcovered options, which has unlimited risk.

[quote=“MaPoSquid”]I think you may not fully understand what is meant by selling covered calls. They limit the upside, but they also hedge slightly against the downside. If the stock remains stable, you get a monthly chunk of spare change off each transaction.

All the “edge” stuff you wrote applies just as much to ANY form of investing, whether going long, short, playing with options, or putting money into a Somali pirate ring.

BTW, the strategy of selling covered calls has limited risk. It’s not like selling UNcovered options, which has unlimited risk.[/quote]

Unless our terminology is different, I understood covered calls to be similar to short selling, only that no leverage is involved. Effectively you rent out the shares to an options trader. You make a small income on this, however if the shares appreciate sharply you may get ‘called’ in which case the option holder will purchase your shares at the pre-agreed price. If the shares go down in price, you will still get your ‘rent’ and you won’t get called, but the next call you write will be at a lower price. Therefore this technique is useful for those shareholders who believe the price may drop or remain steady and wants to protect the downside, with the risk being that they may be forced to sell.

[quote=“Tyc00n”][quote=“MaPoSquid”]I think you may not fully understand what is meant by selling covered calls. They limit the upside, but they also hedge slightly against the downside. If the stock remains stable, you get a monthly chunk of spare change off each transaction.

All the “edge” stuff you wrote applies just as much to ANY form of investing, whether going long, short, playing with options, or putting money into a Somali pirate ring.

BTW, the strategy of selling covered calls has limited risk. It’s not like selling UNcovered options, which has unlimited risk.[/quote]

Unless our terminology is different, I understood covered calls to be similar to short selling, only that no leverage is involved. Effectively you rent out the shares to an options trader. You make a small income on this, however if the shares appreciate sharply you may get ‘called’ in which case the option holder will purchase your shares at the pre-agreed price. If the shares go down in price, you will still get your ‘rent’ and you won’t get called, but the next call you write will be at a lower price. Therefore this technique is useful for those shareholders who believe the price may drop or remain steady and wants to protect the downside, with the risk being that they may be forced to sell.[/quote]
That’s basically got it, except that covered calls aren’t similar to short selling at all. Selling covered calls limits the upside, provides a steady stream of income that is likely to be more than the appreciation of the stock, and has limited risk.

Shorting has unlimited risk and limited upside (max return is 100%, only reached if the company goes bankrupt).

Your earlier comment:

[quote=“Tyc00n”]If he has that edge, why doesn’t he have that edge for identifying stocks that will go up? Or go down? The strategy presumes a fallacy. And market expectations of risk will be embedded in option prices anyway, so the ‘trader’ must know something the market doesn’t.
[/quote]
misses a few things. First, options sell for a premium to the (stock-strike) price; if the stock is at $25, you don’t sell a $25-strike call for zero. You get money based on how volatile the stock is and on how long the option runs. These are calculated to be more than the stock is likely to rise over that period; look for articles on the “Black-Scholes” formula.

Second, what makes you think he can’t identify stocks that will go up or down as well? Third, the trader doesn’t need to know more than the market in order to reap the premiums on a monthly basis; if the market is perfectly accurate, the premium is low, but it will always be positive since it is partly based on time.

The only real risks are either that the stock will rise dramatically, resulting in missing out on the gains, or that the stock will tank, in which case he’s still better off than he would have been if he hadn’t sold the calls since part of that loss is paid for by the calls themselves.

I’m a professional in the field, and have traded more options than either of you will in your lifetime. That is not to brag, but only to make a point.

If you don’t consistently get your stocks right, over time you will lose money selling covered calls. Over 90% of your trades will make money, hence one is easily lured into a sense that it is a profitable strategy. However, those last 10% wipe out all the profits, and more. (When stocks go to zero, they do so in the pre-market, and options liquidity vanishes. There is no exit without giving up a limb.) You are essentially making a portfolio of bets, in which each bet has ~100% downside risk, and limited upside risk. Commissions and spreads are also onerous. Covered calls work well enough in a rising market, but it is a grossly inferior strategy relative to simply going long well chosen stocks. Covered calls will decimate you in a falling market.

But like I said, most people have to learn the truth about covered calls the hard way. So don’t bet the house, and have fun with it.