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Writing Covered Calls in 2010

As mentioned by Tadas at Abnormal Returns, Saturday's online Wall Street Journal had a significant article about covered call writing.  The reporter (Jeff D. Opdyke) interviewed several people to present a diversified set of opinions on the strategy.

Covered call writing is one of my six favorite option strategies, but it does have one significant fault:  Downside losses can be significant.  That's why I encourage more experienced traders to consider less risky strategies, such as collars and the sale of put spreads. 

Note: Writing covered calls is equivalent to selling naked puts, and collars are equivalent to selling put spreads.

I have some comments on that article:

1a) Opdyke correctly states that "Covered calls generate income and can juice returns in any market,
though they often make most sense in a market that is flat to mildly

The covered call is delta long and is a position with a bullish bias.  It makes money when the market rises. Jeff goes on to state: "Selling calls generally makes sense only for investors who don't mind losing the shares they own."  I never mind losing the shares.  When that happens, I know I earned the maximum possible profit available to the covered call writer.

1b) He also points out the obvious negative factors: "But investors still could get hammered if stock prices collapse. And
the big drop in stock-market volatility means investors are receiving
less income for selling calls than they did in the aftermath of the
financial crisis, when high volatility pushed options prices way up."  I agree.  There is no doubt that this strategy has its risks.

2) Jim Bittman, author and Senior Instructor at the Options Institute, and someone I have known for a long time, takes a different view: "If you are bullish about 2010, then don't sell calls because you'll miss out on a rally."

Recognizing that different traders have differing points of view, I disagree with this statement because:

a) A 'rally' does not mean the stock will move as high as the option's strike price.  [Most writers prefer to write calls that are out of the money]

b) You don't  miss out on a rally when you earn a profit on a stock that moves higher.  What you may miss is the opportunity to earn additional profits – over and above the limited profits available to covered call writers.

 But to me, that's unimportant. 

Not every trader has to earn the maximum possible profit from each trade

Seeking the maximum, and taking the risk that goes with that approach, is not a long-term winning strategy IMO

Writing the covered call provides a small hedge and some extra income – just in case your expectation of a rising market does not come true.  We all know how difficult it is to predict market direction, and if I were bullish, I'd prefer to hedge that bias by using a mildly bullish strategy.

3) The director of trading and derivatives at Charles
was not afraid to state that he wrote covered calls during the big rally during the last 9 months of 2009: "I used that strategy throughout 2009, when the market was rallying,"
said Randy Frederick.

He did well with that strategy, even if he might have done better without it.  Making money is the name of the game.  Covered call writing provided nice profits in 2009 – after a very shaky start.  The BXM, CBOE BuyWrite Index gained, 25.9% in 2009,  compared with a 26.5 % return for SPTR (Standard & Poor's 500 Total Return Index).  Thus, covered call writing produced no extra income last year, but it did provide a less volatile ride.


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