Covered Call Writing: Only for the Wealthy?

Originally published Feb 25, 2011 at InvestorPlace

I recently heard an options trading investor suggest that writing covered calls is a strategy that can be utilized only by investors with a big pile of cash.

That is simply not true. Writing covered calls is a strategy that can generate solid returns and is in no way restricted to traders with large accounts. As a long time option educator, I know that options investing and trading can be confusing. Nevertheless, I never heard anyone suggest that investing in stocks is only for the wealthy.

Put simply – to write covered calls, the investor must own at least 100 shares of stock. There are many quality stocks which trade between $20 and $40 a share. Surely buying 200 shares of a $35 stock and writing two calls is not a situation reserved for the wealthy. It requires less than $7,000. While that may be a significant sum for many investors, it hardly separates the wealthy from the non-wealthy investor.

For purposes of diversification, it’s more efficient to own a few stocks rather than only one, and I’d advise people with smaller portfolios to begin by investing in index funds, while steadily adding money to their accounts. When there’s enough value in the account, and if the investor prefers to handle his/her own trades rather than continue to use index funds, then that’s the appropriate time to begin writing covered calls. $20,000 should be more than enough – and yes, I recognize that many investors begin using options with far less capital.

Alternative strategy: Sell put spreads

When a trader recognizes the large downside risk associated with owning stock (with or without writing covered calls), he/she may feel much safer by using alternative bullish strategies. One easy to understand strategy is the sale of out-of-the-money put spreads.

The maximum profit may be limited to the cash collected, but the maximum loss is drastically reduced, and is far less than that associated with owning stock. Any trader who is happy to earn profits with reduced risk should prefer the sale of put spreads to the purchase of stock and the subsequent writing of call options.

Translation: Selling put spreads is preferable for conservative investors who want to limit downside risk. There is no suggestion that everyone should adopt this method rather than own stocks.

For example – when a trader sells a 5-point spread, the XYZ Nov 50/55 put spread — the maximum loss is $500, less the premium collected. Additionally, the margin required to hold the trade is only $500, far less than paying the $2,500 margin required to own 100 shares of a stock priced at $50.

Recognize that there is no need for great wealth to trade this strategy on a small scale. Note those words: ‘small scale.’ The biggest risk associated with this play is the inability to recognize the possibility of losing the maximum ($500, less premium collected). That encourages the not-yet-educated options player to sell 10 of these spreads instead of buying 100 shares. To that trader, each position has $5,000 at risk. There is little chance of losing the entire $5,000 when owning shares, but the chances of losing that (almost) $5,000 from the sale of 10 put spreads is far greater than zero. That’s the risk – selling too many spreads.

To trade options with less capital, it’s advisable to look for risk-reducing spreads. And it’s necessary to trade an appropriate quantity of spreads.

917

22 Responses to Covered Call Writing: Only for the Wealthy?

  1. Lies 03/03/2011 at 6:07 AM #

    Dear Mark Wolfinger,

    I did some calculations with the B&S formula. The calculator i used for this purpose comes from this website:
    http://www.option-price.com/index.php

    I ‘discovered’ somethings strange with the fair value of an option when i buy a call from a firm that pays a huge/royal dividend.

    Assume i want to buy a deep in the money LEAP option.
    – Underlying price: 100
    – Exercise price: 70
    – Days until expiration: 500 days (leap option)
    – Interest: 3%
    – Dividend yield: 7%
    – Volatility 25%

    I know that a dividend will decrease the price of a call option. But on the other hand i know that the minimum price of an option is the intrinsic value. But here i see a discrepancy! The fair value of this option (based on the B&S formula) is 25.45. (caused by the dividend of 7%) but the intrensic value is 30. So this option will never be sold for less than 30.

    So, theoretically the buyer of this option pays to much (30 instead of 25.45).
    Is it correct to say that in a situation where we are going to buy a call option of a firm that has a generous dividend we shouldn’t buy the deep ITM call option (because we pay to much) and we should prefer to write een put?

    Thanks

    • Mark D Wolfinger 03/03/2011 at 8:20 AM #

      Lies,

      The numbers you post are impossible. The value of this call option is not $25 and change. It is at least $30.

      My assumption is that you calculated the theoretical value of a European style option. Such an option cannot be exercised prior to expiration, and all those dividends reduce the value of the stock (and the LEAPS call). Recalculate using American style options.

      By the way: It’s ‘LEAPS’, never ‘LEAP’ nor ‘leap’

      Regards

  2. Lies 03/03/2011 at 9:12 AM #

    I did the calculation again with a calculator that can calculate options of American style.
    I took it from this website:

    http://www.varcalc.com/calculators/varcalc/scripts/AmericanOptionBAWDivCalculator.html

    He says that the fair value of this option is 20.7 and 18.46 for European style.

    Strange… The numbers are different, but even this one gives me a result that lies under te intrinsic value.

    • Lies 03/03/2011 at 9:15 AM #

      The previous post is fault.

      It has to be:

      The american style option is 30.
      And the European style 25.

      So the second option is fair valued under the intrinsic value.

      • Mark D Wolfinger 03/03/2011 at 9:47 AM #

        Lies,

        Yes. Because it cannot be exercised for the dividend, then the stock price – as far as that deep ITM option is concerned – is the current value of the stock, less all dividends.
        That’s why it trades below current intrinsic value.

    • Mark D Wolfinger 03/03/2011 at 9:45 AM #

      Try the CBOE/iVolatility.com calculator: http://bit.ly/f3gcfW

      You know that the option is worth intrinsic value. You know it.

      If you sell it for a dime less, the buyer will short the stock, exercise the call, and lock in that 10 cents. Immediately, if it is deep ITM.

  3. Lies 03/03/2011 at 9:33 AM #

    I’m sorry i have to open a new post, but apparently i can not edit my previous post.

    So what i want to make clear is that you always have to pay the intrinsic value (in this case 30). When i change the dividend to 6%, you still have to pay the same amount of money as if the firm pays a dividend of 8%. Because of course you cannot pay less than intrinsic value.

    So i think that an investor should choose a call with a higher strike where there is an extrensic value that can be exposed by higher dividends.

    Sorry, for a new post and possible grammar faults (Englisch is not my mothertongue).

    • Mark D Wolfinger 03/03/2011 at 9:51 AM #

      Lies,

      I’ll see if I can find a way to make posts editable.

      Correct on intrinsic value. You, the individual investor cannot pay less. However, some people are dumb enough to sell below intrinsic value when that is all the market maker is willing to pay.
      When that happens, never sell the call to the market maker. If you are selling an option you already own: exercsie and sell the stock. If you aare writing the call, then it’s foolish to sell below intrinsic value (parity).

      The truth is that HIGH dividend stocks do make make good covered call candidates. However, if anyone wants to trade such a call, a higher strike price must be chosen. But that imparts greater downside risk.

      Regards

  4. Libor 03/03/2011 at 9:48 AM #

    Here is the link on very nice study regarding effectiveness of covered calls. http://seekingalpha.com/article/255338-do-covered-calls-improve-expected-returns

    • Mark D Wolfinger 03/03/2011 at 9:54 AM #

      Thanks Libor,

      CBOE offers the data, allowing anyone to draw his/her own graphs from that data. http://www.cboe.com/micro/bxm/

  5. Joe 03/03/2011 at 12:17 PM #

    Mark,

    I have not been able to find the answer to this question on “educational sites” yet, but was wondering if you might know, and this discussion is about bull put spreads…

    What happens if on expiration day, the price is lingering near your short strike price and you assume (or think) it will expire worthless, but at the very end of the day, moves to just below the short option strike, even by a nickel??? CBOE automatically exercises all such puts, and so come Monday morning, I presume that I have purchased 500 shares of XYZ at the short strike price. (for 5 contracts sold…) What about the long puts? I presume they expire worthless and too late to help, so at the close of the day, I really am no longer in a spread, but am short, and have bought 500 XYZ, even if only pennies below the strike price… This could end up being reason for a margin call, when spreads are supposed to enable one to avoid such things…

    My question is whether my neutral position (long and short) would cancel the short position and keep the Option Clearing from assigning to me. I believe if I am assigned early, my broker would automatically close out this position if assigned and didn’t have the funds to buy 500 XYZ (say, thousands of dollars worth). I’m a bit perplexed on this situation, since I can see this as a possibility, when underlying is trading near the short side strike. Does this mean that “max profit” when opening the position is really not do-able unless XYZ is quite a bit OTM (because you would have to close position on last day)

    Is this a concern and should I just close the position on option expiration day? If so, what really is the “last hour” you should wait?

    Thanks,

    Joe

    • Mark D Wolfinger 03/03/2011 at 2:08 PM #

      Hi Joe,

      For simplicity, I refer to a ‘bull put spread’ as ‘selling a put spread.’

      1) CBOE does not exercise options. Your broker, in conjunction with the Options Clearing Corporation handles that chore

      2) Yes, it’s realistic to assume you would own $500 shares at the strike price

      3) Your long puts were 5 points OTM and expired worthless

      4) Yes, you could have a margin call. However, that is not the fault of the ‘spread.’ That’s your fault for not buying back those short options at a low price. When they were ATM, you could have paid $0.10 or even entered a bid of $0.05. Not doing that imparts risk – and in this example, you own 500 shares of stock

      5) No. Not in a million years. You would be assigned. First, no one knows or cares whether you own one series of puts. You sold other puts and were assigned an exercsie notice. That’s the end of the story. Second, no one (broker excluded) cares whether you have cash to buy the shares. There is no mercy. You will be assigned.

      The position is far from neutral. It’s protected in that losses are capped, but it is delta LONG and not neutral.

      6) If your broker is the type who automatically closes the trade – when you have a margin call – without giving you a chance to do anything, they will do so by selling as many shares of stock as necessary so that you can meet the margin call. They are not likely to sell all 500 shares.

      7) The ‘max profit’ is always a theoretical number. It is the most you can earn if and only if all goes well and the options expire worthless.

      8 ) Yes, this is a HUGE concern. And there is NO REASON to wait until the last day. In my opinion, it is foolish to ever attempt to earn the max. I always cover by – buying back the spread -when the price is low enough. I don’t know what low enough means to you, but for me, $0.15 to $.20 is a great buy-back price. I begin by selling near $1.50.

      No matter how you trade, waiting until the last day makes no sense. The big money in options trading (for premium sellers) comes from earning the bulk of the potential profit), and allowing some other risk-taker to have the last few nickels. The big risk in options trading is incurring large losses or unnecessary losses. Is it really necessary to earn the ‘Max” and risk turning a nice trade into a loser?

      If you are going to buy back the option sold, the longer you wait, the more risk you take. Why wait? Just buy bask as soon as it gets to your ‘low price,’ even when that’s a couple of weeks prior to expiration.

  6. Joe 03/04/2011 at 8:36 AM #

    Mark,

    First, sorry about the mis-typing, I meant the OCC…

    Thanks, I appreciate your insight. All the education programs I have read on these subjects do not discuss the issue I am bringing up. They PRESUME you will allow the short to expire worthless. Every one of them teach this, that I have seen. “Allow the short to expire”…

    After some thinking, I begin to think of a situation where I could get killed, despite the supposed long put for hedging. That would be allowing the short to expire worthless (say it is a half point above strike at open), finding it didn’t (say, a nickel under strike, falling 55 cents) and being assigned without the hedge in place anymore, since the long put is worthless after closing – while the assignment is in force “after” closing.

    My luck would be when I go to sell the assigned stock Monday morning (before settlement is due), XYZ would gap down! Oh, what a turn of events. Walking away Friday afternoon thinking you got max profit and learning Monday morning you are a desperate guy trying to sell stock in a falling market to cover margin!

    In the future, I will have to adjust “max profit” to assume a closing transaction. “Selling at $1.50”, as you said, would naturally assume that you opened at a higher spread! If my initial opening spread was 1.00, I think I could look at a smaller spread, but definitely, the day or two before would be a good time to look at the time decay and buy to close out the spread. Even four days before expiration, there is still a healthy amount of time decay left.

    Thanks again for confirming my fears on this.

    Joe

    • Mark D Wolfinger 03/04/2011 at 9:23 AM #

      Hi Joe,

      1) Everything you describe in this comment can be avoided by repurchasing your short option. Why in the world would you want to subject yourself to the scenario described, no matter how unlikely it is? The risk/reward are totally out of sync. You save $5 or $10 per contract every time it expires worthless – but open the chance of ‘getting killed’ every once in awhile. This is not the path towards a long and profitable trading career.

      2) Glad to confirm your fears. They are well-founded fears.

      3) Yes, do assume a closing transaction when calculating maximum profit.

      4) But I don’t think I helped you to understand the point about buying back the short option, or (better yet, in my opinion), buying back the credit spread. There is no point in waiting. As soon as the price reaches your target, buy it. The longer you wait, the more risk you incur. For example, I am bidding 10 and 15 cents to buy back some March spreads. I am also 20 cents bid for an April spread. And don’t believe that this does not work. I’ve already covered some OTM April put spreads by paying 20 cents. You may prefer to bid only a dime, but bid. Enter the order.

      One more point: It is far easier to buy your spread at a low price than wait to buy back only the short option at your price. The point is to pay the same dollars and get out sooner. If the cost of commissions enters into your decision-making on this trade, then you are using the wrong broker. Trade decisions and risk management are far more important than being concerned with your brokers commission structure. If you hate those costs, move the account. Otherwise don’t sweat the small stuff.

      Regards

  7. Joe 03/04/2011 at 10:57 AM #

    Mark,

    Thanks again for your reply…

    I was under the impression that time decay wouldn’t allow you to close out your spread (at “20 cents”) until the last couple days. Is it possible to happen two weeks out? I guess if the underlying went deep OTM, say well over 10% of your short strike. You have given me some food for thought and will consider a conditional order. I presume you figure 20 cents as the point of closure when figuring out max profit? CBOE has a nice options calculator where you can change the underlying, time to expiration and strikes to figure theoretical price of options.. Seems like from day 4 to day 2 (all else equal), you have a pretty significant drop in your buy back price for your short side.

    But certainly, if the price goes up quite a bit, I’ll have to keep an eye on the spread (for the put spread, of course..).

    Thanks Mark,

    Joe

    • Mark D Wolfinger 03/04/2011 at 2:03 PM #

      Joe,

      I missed replying to this one earlier. Sorry.

      Sure the spread can get to 20 cents or less far before expiration. I’ve already closed one April position. When the options move far enough OTM, the price shrinks. However – if you wait to cover your short option – that is going to require far more time. When you are willing to let go of your long option and bid to buy the spread – you will be filled much more quickly.

      To be honest, I never think about “Max profit.” I know that I open new IC positions and collect ~ $300. I also know that I will cover any side at any time that I can do so by paying $0.15. I pay $0.20 when there’s more than one month remaining in the life of the options, and if I were to bid for some May shorts today, I’d bid $0.25.

      If I hold a position longer than I prefer – and that’s the case when the options become front-month options – then I set a price for the whole iron condor and bid for that. If I’m still holding March positions (2 weeks prior to expiration) as I am today, I forget my need to pay only fifteen or twenty cents per spread. I’m far more anxious to exit and will bid $0.50 or $0.60 to exit the whole iron condor. To me, the profit is sufficient and I want to get out of short-term risk.

      That works for me. you may decide to do something different. My bottom line is that I know there is enough profit potential in the trade that I do not have to record a maximum profit into my trade plan, trade journal, or anywhere else. If you do keep such records, then – yes, I think it’s best to assume some debit will be paid to exit.

      Thanks

  8. Joe 03/04/2011 at 11:02 AM #

    Mark,

    Forgot to add this question on our discussion…

    I had heard that it wasn’t a great idea to place long-standing limit orders to close out spreads, as it allows market makers to guage the market (at your disadvantage) and that conditional orders were better. What are your thoughts on that?

    Joe

    • Mark D Wolfinger 03/04/2011 at 12:14 PM #

      Joe,
      Nonsense. It’s a bad idea to place GTC OPENING orders, but when bidding a very low price to exit a trade, lock in your profits and eliminate risk – who cares what anyone thinks of the order? And I guarantee that no one will learn anything useful from that order.

      I never suggested GTC. I enter my order every day, and sometimes I bid less than I bid yesterday.

      Conditional order? What sort of conditions would you place on an order to buy a put or call spread at $0.10? And once again, if you enter the order daily, you don’t ever have to think about these things – none of which mean anything.

      You are way over-thinking. This is a trivial matter. Trivial. Unimportant to anyone except you.

      Once you own the position, and once it is reasonable to believe the order has a tiny chance of being filled, enter the bid. If the spread is already 50 cents bid, then there is no point in bidding 10 cents.

      You will NOT be entering this bid right away. Time must pass or the market must move before you have any chance to exit at a cheap price.

      I truly hope you get this. You either believe in exiting early or you believe in holding to the end. It’s not a difficult decision.

  9. Joe 03/04/2011 at 1:47 PM #

    Mark,

    I appreciate your response. Perhaps it is not your intention, but you sound a bit condescending. I apologize for my rookie “worrying about such unimportant things that are important only to me.” But I do thank you for answering the question, just the same. I suppose rookies in every field must be made to look foolish…

    Regards

    • Mark D Wolfinger 03/04/2011 at 1:54 PM #

      Joe,
      That was not the intention. I was just trying to reassure you that entering a GTC is nothing to be concerned about. MMs always have an edge over us because the order sits there and they can take it when it suits them. But that’s true for a day order as well as for a GTC order. It’s never right to use a market order.

      In my opinion, I’d rather get my fill at my price, and give the MM the advantage – rather than try to get a better price at another time.

      Once again – I was trying to stress that this is truly not a big deal. If you remember to exit early, you will avoid the nightmare scenario that you mentioned earlier. That’s why it’s not ‘important’ to anyone else. No one cares about my ten-cent bids and they will not care about yours either.

      It was not intended as a put down and if that’s how it was seen, I truly apologize

      Regards

  10. Joe 03/07/2011 at 6:19 AM #

    Mark,

    Apology accepted.

    thanks again for the advice. I have no problem with leaving a dime on the table. Just hadn’t heard it advised before in other educational programs. It’s good advise. From my reading of the past, it’s presumed that you are holding to expiration or cutting your loses. There is very little said about closing a position just before expiration to avoid the assignment on the last day – and without your long put hedge.

    It’s good to know this. Thanks.

    Regards,

    Joe

    • Mark D Wolfinger 03/07/2011 at 7:49 AM #

      Joe,
      I don’t know why it’s true, but far too often the student is told how to enter a trade and is then abandoned.
      Trade management is far more important than choosing an entry.
      It’s not horribleto hold out to the end. Just too much risk for my taste.

      Thanks for writing.