Covered Calls: Bullish or Bearish?

Mark,

You said selling a covered call is bullish, I think it is bearish. By selling you are making a “bet” that the strike price is too high. Buying a call would be a bullish bet.
Marty

Marty,

Your perspective is somewhat unusual – I’m not saying it’s incorrect – just that it’s different.

I also see that you don’t recognize that options can be used to hedge, or reduce the risk of owning an investment. To you, options are to be used only for speculation. You are free to use options that way, but you are losing out on some of the characteristics of options that makes them so special.

I consider this discussion to be important to the options rookie who is looking for a solid options education.

Without any market bias, these statements about a covered call position are all true:

  • The position is delta long
  • The position earns money when the stock moves higher
  • The position loses money when the stock moves lower
    • Those are NOT the characteristics of a bearish position.

      Profits are limited for the covered call writer

      • That is not bearish
      • It’s a trade-off. The stockholder collected a cash premium now in exchange for potential profits above the strike price later
      • Consider the trader who buys stock and sets a profit target. That’s a bullish trader
      • That’s exactly what the covered call writer does. He/she sets a sell price and collects a cash premium
      • A bearish trader would NOT own stock

      The wager

      Is the bet really that the strike price is too high?

      That is overly simplistic and tells me that you use options purely to speculate. By wring a covered call, the stockholder sells someone else the right to all profits above the strike price – for the lifetime of the option. In exchange he/she gets paid today.

      That’s not bearish. It is a ‘bird in the hand’ investing style. The trader takes the option premium now instead of possible profits later. It’s not a wager to be won or lost. It’s a trade. If the stock goes much higher, that’s a good result. The stockholder wins. From you speculative thinking, the stockholder loses. I do not understand how you can survive as a trader if you are not happy with a profit – just because you could have earned more money had you chosen a different strategy.

      I’m thrilled to write a covered call and be assigned an exercised notice. That’s a winning trade. More than that, it’s the best possible result – after I decided to write the covered call.

      The bullish bet

      Owning stock is a bullish bet. If the stock moves higher, the trader earns a profit.

      Buying a call option is a bullish bet. Yet, if the stock moves higher, there is no guarantee that the call owner will earn a profit. There may even be a significant loss.

      Owning a call may give the trader a chance to make money on a rally, but far too often the trader buys the wrong option (strike price too high) or pays too much for time premium (rapid time decay that hurts the option’s value when the stock price does not increase quickly enough).

      Leverage works both ways. An inexpensive call option can return a large profit, but it can also expire worthless, even when the stock has rallied.

      Buying at the money or out of the money calls is highly speculative, and it takes the right set of conditions to deliver a profit. If the calls are deep ITM, that’s a smarter play. However, I’m certain that’s not the idea you were suggesting.

      Thanks for sharing your thoughts.

      944

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25 Responses to Covered Calls: Bullish or Bearish?

  1. Dmitry 04/08/2011 at 7:13 AM #

    Isnt writing covered calls the same as cutting off the most of the profit side of the P/L distribution curve? This is opposite to the trading logic – avoid big losses while trying to achieve big profits. All the technical trading assumes low risk trades – lose small, gain big.
    Covered calls also dont seem logic from investor`s point of view: carefuly selecting stock based on whatever reasons would be a waste of time by selling it some 5% higher..
    Risk must be rewarded accordingly, and CC eliminate the adequate rewards for relatively high risk of owning stocks without stoplosses..
    By being assigned we lose the stock and receive cash, which should be invested again somewhere else. The current stock was already bringing profit – the investor was right (or lucky, doesnt matter), while the new investment is still questionable.. Reinvesting in same stock would be strange – given that we missed the desided move (if price >> assigned strike). So isnt writing CCs some kind of self-deception from this point of view?

    • Mark D Wolfinger 04/08/2011 at 8:27 AM #

      Dmitry,

      Sure, from that point of view.

      But I take the point of view that no matter how carefully I research an investment, there is little likelihood that my stock will outperform the market. If you have a proven track record of being able to pick winning stocks – and I do not – then that’s good for you and certainly changes your investment strategy. You can play for the big up moves.

      For me, when I look at the overwhelming evidence that demonstrates that professional money managers cannot outperform the market averages, I just know that I cannot do any better. In addition, that research takes far more time than I have and I am not going to try to be one of those people who get high salaries and do a terrible job. I’ll happily take the option premium in place of some possibility of being able to earn a larger profit. I win more often, even when the gains are smaller than yours.

      That doesn’t mean that you should do it. It doesn’t mean that I endorse writing covered calls as a long-term strategy. It is risky There is big downside danger. That’s why I personally prefer the collar (I never trade the collar. I sell a put spread, which is the equivalent strategy).

      Different traders have different needs. I don’t seek the big gains becasue I know I lack the stock-picking talent to achieve those goals. If you do, they by all means, don’t sell covered calls.

      I trade options. That means I try to earn money by skillfully adopting option strategies in a market neutral manner. I don’t trade stocks, and have no idea if the market is heading higher or lower. That perspective is vastly different from yours. And the good news is that options are very versatile and can be used by both of us.

      [Per your request, I do plan to add a forum]

      Regards

  2. Lies002 04/08/2011 at 9:03 AM #

    Hallo,

    I read that you prefer to sell the put spread (instead of the collar). If buying a call spread is the same as selling a put spread (risk/reward) is there a reason why somebody should prefer selling the spread instead of buying?

    Thanks

    • Mark D Wolfinger 04/08/2011 at 10:32 AM #

      Lies,

      Selling a put spread is equivalent to buying the call spread – when the strikes and expiration date are identical.
      There is no theoretical reason for choosing one over the other, but there are practical reasons for selling the put spread.

      1) If you win, the options expire worthless. With the call spread, you must exercise one option and be assigned an exercise notice on the other. Many brokers charge fees for doing this.
      This single item is all the reason one needs to sell the put spread.

      2) Lower priced (OTM) options are easier to trade than higher priced (ITM) options. There are more public orders. The markets tend to be tighter. Thus, if one of the spreads is OTM, it may provide a better execution price.

      3) It always feels better to have the cash in your account – although at today’s low interest rates, it does not matter

      Regards

  3. Dmitry 04/08/2011 at 9:11 AM #

    I just dont get it. The only reason to put money into market is to earn profits. The easiest way (assuming I dont believe that i`m a good stock picker) would be buying SPY/QQQ/DIA.. whatever.. The only reason to go deeper – that is buying sector ETFs or individual stocks – is to outperform indexes. But writing calls eliminates even the posibility of outperforming, doesnt it? We dont know which stocks will go up, so we diversify. If we write calls on all equities in the portfolio we are just neutralizing the potential to outperform..

    • Wayne 04/08/2011 at 9:41 AM #

      Not necessarily. Buying SPY/QQQ…..doesn’t necessarily guarantee a profit. Sometimes when the market goes down, despite the diversification in an index, then just don’t expect that your SPY, QQQ….will one day go up. It may not go up to a level that you can realize a profit; or even if it does, it may take so long that you’re better off investing your money somewhere else.

      Mark, I know you’ve got a lot to respond, but I want to know what you think of the married put strategy, for small income and profit. It doesn’t get mentioned a lot. With this strategy, isn’t it kind of good to know that the profit is unlimited, while having the protection on the side with the long put?

      • Dmitry 04/08/2011 at 9:57 AM #

        Im not saying that indexes guarantees profits. Im saying that any profit lower (or loss greater) than index would be unacceptable, a waste of time.

        • Mark D Wolfinger 04/08/2011 at 10:51 AM #

          D,
          But how can you know, in advance, which stocks will underperform or outperform? I don’t believe that many people can do this. If you do believe you can, then that gives you a huge advantage over everyone else.

          • Dmitry 04/08/2011 at 11:25 AM #

            I dont know, as a CC writer dont. From this perspective we are equaly positioned by not knowing what will occur with a stock, but I dont have a capped upside, and that`s sure look like an advantage.
            Please understand that this is just theory, I`m just curious why would some one want to write calls. It doesnt mean that I`m always in the market 100% bullish. I love hedges, I like trading – would it be technical trades, daytrades or ICs. After all it doesnt matter HOW to make money, right?

          • Mark D Wolfinger 04/08/2011 at 12:16 PM #

            Dmitry,

            Yes, it does matter how you make money. Some people love to gamble. For some even Treasury Bills are too risky.

            Covered call writing has its benefits. It may APPEAR to be an advantage to not cap upside profits, and it is true that covered call writing under performs the S&P 500 index during big bull runs. Nevertheless, covered call writing always outperforms during bear markets, steady markets, and slightly bullish markets. You exchange all of that to allow yourself to have some gigantic years. That’s fine. Nothing wrong with that. Buy why can’t you see that someone may prefer the steadier profitability of writing covered calls.

            But there is nothing wrong with capping upside profits when THE TRADER WHO DOES THAT likes the arrangement. You may not like it. You may prefer to go for the huge win. But that has nothing to do with everyone else on the planet. Each of us gets to chose his/own preferred style of trading and which strategies we use.

            You keep stating that you are curious, or that you don’t understand why anyone would write covered calls. Ok, I don’t understand why anyone would be 100% invested on the long side with no protection. It baffles me. It stuns me. It flies in the face of evidence that shows that hedging with options has been more profitable than owning stocks outright – over a 30 year period. Yes, it’s only 30 years, but CCW is not inferior to buy and hold. I recognize that you disagree. I respect that opinion. It is shared by many. But you don’t seem to be able to see both sides of this issue. I don’t know how to explain it any differently. The record speaks for itself. Unless you pick stocks that outperform on a consistent basis, it’s better to buy indexes. It’s also better yet to write covered calls on those indexes.

            Regards

      • Mark D Wolfinger 04/08/2011 at 10:50 AM #

        Wayne,

        Nothing guarantees a profit, unless it is a successful arbitrage.

        Let me put it this way: I LOATHE the married put strategy. In my opinion is is stupid beyond belief. The ONLY possible reason for owning a married put is that you cannot afford to sell the stock (taxes) and want to hold. Otherwise it’s just plain dumb.

        Think about this: “isn’t it kind of good to know that the profit is unlimited, while having the protection on the side with the long put?”

        Unlimited profit?
        Limited losses?

        How is that different from owning call options?

        That’s the point. It’s not different. The married put IS a call option (synthetically). That means the married put performs exactly the same as owning the call with the same strike and expiration. It’s easier to trade the call than to buy stock and puts. Do you want to own a portfolio of call options? Probably not.

        Again there is an exception. If the options are sufficiently ITM, then owning them is BETTER than owning stock. Here are some of my thoughts.

        • dave Appel 04/09/2011 at 11:24 AM #

          Hi Mark,

          I very often share a similair point of veiw as you do and have gained tremendous knownledge from your book and blog. How ever i strongly disagree with the comment that married puts are stupid. What if you get a strong overnight move in a stock or etf for that matter. You have overnight protection then. You maybe unable to sell your stock in the pre market . The put protects against that overnight price gap. And those of us with day jobs that don’t have a tremendous amount of time to watch markets especially fast markets may be protected through this strategy as well. I can’t see how thats a bad strategy.

          • Mark D Wolfinger 04/09/2011 at 8:25 PM #

            Hello Dave,

            Just buy the call. Why bother with the protective, or married put? It’s the same position.

            It’s easier to own a call option that to own stock plus a put. It is the equivalent position.

            My language is too harsh, and I apologize for that.

            Regards

    • Mark D Wolfinger 04/08/2011 at 10:40 AM #

      Dmitry,

      Yes. The reason is to earn profit. I agree.

      Why is buying a broad based index the ‘easiest’ way. Don’t markets ever go down when you are invested?

      Writing covered calls has been shown to outperform buy and hold (the SP 500 Index). The out-performance is not large, but it is real. And even better – it produces a portfolio with smaller swings. In other words, the portfolio value is less volatile. That’s good for sleeping at night.

      Yes, you are neutralizing the chances to outperform by a large amount. But I must ask, why do you (and almost everyone else) always assume that markets go higher? Writing covered calls also reduces losses when markets decline. And it vastly outperforms when markets are stagnant.

      You can be 100% bullish. There is nothing wrong with that. However, many investors/traders want to HEDGE. They want to reduce the risk of owning investments. You cannot get that hedge for nothing. You must pay something. I prefer to pay by capping my profits. Others prefer to pay by owning puts. Others hedge by selling some of the shares on rallies. There are many ways to hedge. You prefer not to hedge – and that’s perfectly understandable.

      However, you should be able to understand why some people like that hedging idea.

  4. Dmitry 04/08/2011 at 11:08 AM #

    Buying index is simpliest because it frees the investor from the emotions associated with making desicions while providing wide diversification. If we cant time the market we can just always be in. Im not talking about myself – im talking about some average middle-to-upper class human willing to invest in stocks. He does that to try to achive a better return than bank deposits can offer.

    I do assume that markets always go higher because i have no reasons not to think so: since late 1800s when Dow introduced the indices market did grow (with occasional periods of losses).

    I just dont see a point risking by making desicions (choosing stocks to write calls on) that doesnt pay off. I assume it would take some time and effort to choose the right stocks, the right calls etc. and an overage human would actualy underperform. So for me it`s just a choise – waste time and effort which wouldnt significantly change the end result (or worsen it) versus doing nothing by owning index, obtaining comparable results. That`s why I see writing calls somewhat counter-productive, that`s my personal opinion. Neighter I own SPY by the way, guess to have a stockpicking “track record” one should at least try 🙂

    And for the hedges – I am trying to use iron condors as a “credit hedge”. Somehow protecting on the downside while still allowing profits upside. Looks good for me in theory, without capping profits.

    Sorry for the long posts.

    • Mark D Wolfinger 04/08/2011 at 12:05 PM #

      Dmitry,
      Long posts are ok

      1) Writing covered calls is not for everyone. It is far from my favorite strategy

      2) Investing in the stock market is not for everyone

      3) I agree that it’s more efficient and simpler to invest in index funds of broad-based ETFs

      4) For investors who do not pick their own stocks, they can write covered calls on ETFs.

      5) Iron condors cap profits and have significant upside risk. They do not protect the downside as they also have significant downside risk.

      6) I am not trying to convince you of anything. Just replying as to why some people would want to write covered calls.

      Regards

  5. Dmitry 04/08/2011 at 12:29 PM #

    Thanks for the responses.
    as for 5) Iron condors cap profits and have significant upside risk. They do not protect the downside as they also have significant downside risk.
    I did not mean trading IC on stocks, I meant having a portfolio of stocks and hedge the whole portfolio with index iron condors. Im sure it`s not a best way to hedge but its credit and the flexibility of an IC that i like. That is also why im so interested in chosing the correct IC contract size..

  6. Dmitry 04/08/2011 at 12:36 PM #

    btw, sorry for being dumb but: how is covered call writing always outperforms during bear markets? I buy the stock, i write the call, stock falls, i cannot sell the next call because i would take a realised loss if assigned.. or are we talking about some very slow bear market?

    • Mark D Wolfinger 04/08/2011 at 1:07 PM #

      Dmitry,

      You are not dumb. And I know that you know that.

      If you own stock and do not sell the covered call, you lose MORE THAN the covered call writer. That’s why the CCW outperforms. He/she is better off by that amount of premium collected. That trader may have a big loss, but it less than that of the naked long stockholder

      This is VERY important. It is also an OPINION and not proven fact. We can debate this at a live meeting, if you want to do so.

      You are allowed to take a realized loss.
      You cannot win on every trade.
      If you refuse to take loses you will never survive. You will own a portfolio of losing trades.
      A trader cannot (must not) hold every losing position, hoping it will recover.

      *** If I have a stock that is currently trading at $38 and if I decide that I like the benefits of writing a Dec 40 call, then I will sell the Dec 40 call. ***

      It does not matter what my original purchase price was. All that matters is that the stock is $38 today, and I have two choices (assuming I still want to own the shares): write the call or do not write the call. My original purchase price is not important. It does not play a role in my decision. It is 100% irrelevant. You will make far more money over the years if you base your trade decisions on what is right in front of your nose.

      In other words: Forget yesterday. Look at your positions. Do you want to own them right this minute? Do you want to buy more right now? Do you want to sell right now? Do you want to adopt an option position right now? Answer those questions. Trade based on those answers and not on the original cost of the position. That’s how to manage risk successfully.

      Feel free to disagree. Many do.
      Regards

  7. Robert D. 04/08/2011 at 6:44 PM #

    Mark,

    I would argue that the best possible outcome for a CC position, especially for small trading account, is when the stock closes at exactly the call’s strike price upon expiration. This way, the call does not finish ITM and you’ve captured the maximum upside without having to pay a commission for assignment. Would you agree?

    Robert

    • Mark D Wolfinger 04/08/2011 at 7:33 PM #

      Robert D,

      Sure that’s right.

      And finishing a penny lower is even better as there is virtually zero chance of being assigned an exercsie notice.

      However, those are rare events and thus, I generalize when I say that being assigned is ‘the best possible’ result. It would be more accurate (but extremely awkward) to say: “the best result among the likely possibilities is for the option to finish ITM and for the CCW to be assigned an exercsie notice.”

      However, you are correct. I’ve include your point in webinars, but when the explanation is in writing, I feel it makes things a bit complicated for the beginning trader.

      thanks

    • rluser 04/11/2011 at 9:06 AM #

      One could choose a broker that charges no commission for assignment to avoid the distinction.

      • Mark D Wolfinger 04/11/2011 at 9:50 AM #

        rlu

        Yes. I use such a broker. But remember, sometimes full-service brokers are family friends or relatives and it’s not so easy to switch for a small number of people.

  8. Marc 02/23/2014 at 6:12 PM #

    Hello Mark,

    I was reading this older thread (2011) with a lot of attention. And I read ‘The short book on options’.
    Before 2 years I wasn’t trading stocks. I am 48 years old. During those 2 years I learned a lot through a educational Belgian website (www.monest.be) and by reading (Stan Weinstein Profiting in bull and bear markets, Justin Mamis When to Sell, Tarp and Trade your way to Financial Freedom, SWhager Market Wizards, Masonson Buy don’t Hold, Dorsey Point and Figure Charting…). And after one year I was able to choose a strategy with Point & figure charting and relative strength. And I am cutting my loosers!

    In addition, I would like to start using options to protect certain positions or to have a outlook for a bullish position when I am trading against my max total risk for the portfolio.

    Anyway, 2 weeks ago I sold my first covered call 😉
    And I would like to know your point of view…

    I bought CRS stock (Carpenter Technology Corp) on 19 nov 13 on an outbreak at 62,21.
    But after the outbreak, the stock didn’t move up but kept moving sideways between 57 and 62,5. Meanwhile the market was hesitating.
    Somewhere around 30 jan 2014 CRS would com up with earnings. During that time I eventually wanted to keep the stock but above all I wanted to have some downside protection because of the upcoming news.
    A that time my stop loss for CRS was at 56,67

    Because of that, on 29 jan 14, I took away my stop loss and I wrote a ITM covered call (CRS was trading at 58,50) CRS/jun14/55 at a premium of $5,60 (IV 26,70%, Delta 0,67). Open Intrest was 12…I needed more 🙁

    These were my thoughts and calculations
    ITM call > the call will probably be assigned (or I need to roll down or buy the call back at a lower premium)
    ITM call = more downside protection

    My original investment was 62,21 (the stock I bought) – 5,6 (the premium of the CCW) = $56,61
    Time value in the premium was 5,6 – 3,50 (actual stockprice when selling the call 58,50 – strike of 55) = 2,1 (profit potential)
    Original investment 200 x 62,21 = $12442
    Minus option premium 200 x 5,6 = -1120
    Net investment = $11322

    Max return = profit potential (200×2,1)/net investment = 420/11322 = 0,037 or 3,7%
    Protection = premium earned/original investment = 1120/12442 = 0,09 or 9%

    Right now I am still bullish about the market and the stock.On the other hand, I am aware of the risk if the stock would undergo a price decline below $55! If it starts trading below $55 (a point and figure sell signal!) I need to get out!
    In other words, I hope to buy back the call and write a new covered call, probably a slightly OTM call.

    Thank you for your reply,
    Marc (B)


    Hello Marc,

    I have no quarrel with your trades or your plan. You bought stock when bullish and you hedged the position after a stock price decline. Obviously you could have timed the trade better. But here is the key point: If your charts gave a buy signal and you went long, you did the right thing. It is important to know (as I am sure you do) that buy signals are never 100% accurate.

    When the price declined and you became uncomfortable, you picked up some good premium and therefore some decent downside protection. Another good decision. NOTE: I cannot say whether this was the best option to sell, but who cares? All you want to know is that you made a good choice and that you are comfortable owning the current position.

    The small open interest may be a problem, but (against the majority opinion), I don’t worry about such things. If this is the stock you prefer to trade, then you will have to deal with the low OI problem. But there may be no problems. And, OI will be higher by the end of January.

    If you still own the position when Jun expiration arrives, and if your call option is in the money, you can lose the position (via assignment) and take your profit. Or, at that time you may prefer to cover the Jun 55 call and sell another, longer-dated call option. But that is in the future and of no concern right now.

    If the stock moves under $55, then you can sell the stock, but you would also have to buy the call. The big risk for you is that the stock could have terrible earnings and gap open well below $55. However, that is the same risk that every stockholder has when earnings are going to be announced. I assume you are comfortable with that risk — and if so, there is nothing you have to do now.

    Here is a possible problem. I note that by ‘get out’ you plan to buy the Jun 55 call and sell another call, bringing in more cash and lowering your cost basis. Nothing wrong with that plan, as long as you are still bullish on the stock. But if the P&F charts give you a sell signal, will you still want to own stock? I cannot answer that for you.

    One suggestion. I know you have 200 shares. However, when discussion a position is is far easier to understand when we speak in terms of 100 shares. Then you can multiply the numbers by two (or whatever the number of shares) to come up with real profit and loss. But is easy (for me) to think in terms of investing $56.61 per share than looking at $11,322 and dividing by two.

    Best of luck with this trade.
    Mark

    • Marc 02/23/2014 at 6:25 PM #

      In addition, here is a link to the option Matrix with the details of the covered call write when I wrote it…

      http://snag.gy/JY97c.jpg