Let’s say I sell a covered call with the stock @ $10 and strike price
is $12. As I understand it, there isn't any way my stock would get
called away if the stock price goes to $5. What you are saying is I am
losing money because of the stock I bought. You are presuming it is now
worth less if I sold it, and not that it will be called away.
MDW: If you write a covered call, as you describe it, with the stock trading at $10 – and if the stock drops to $5, you lose money.
The money is lost because the stock is $5 lower than it was when you wrote the covered call.
When the stock price declines, it's worth less than it was before. That's the definition of losing money with an investment. The stock was worth $1,000. Now it is worth $500. That's a loss.
That loss is decreased by the small premium you collected when selling the call struck at 12 (strike is 12).
Yes, I am not presuming that your stock will be called. But, I am not presuming 'it is now worth less.' It is worth less. And that's true whether you keep or sell the shares. It is worth $5 per share than it was worth when you wrote the covered call.
In other words, if the stock goes to $5, the buyer of my covered
call could not buy it from me for $5. He would have to pay the strike
price of $12 which he wouldn't do, right?
MDW: Right. The option owner has the right to buy stock at the strike price, and at no other price. In this example, that's $12 per share.
Right again. He/she would not exercise the option to pay $12 per share.
The falling stock price could hurt me only if it falls below my
entry price. So if I own stock I bought at $2, and it goes to $10, then
I sell a covered call with a strike price of $12, the stock retreats to
$5. I have not lost money, have I?
MDW: No. This is a very big misconception. I do not understand why you would say this. This stock was trading at $10 per share. You decided to write a covered call against those shares.
That decision hurt you.
You could have sold the stock instead of writing the call. You could have collected $1,000 per 100 shares. Today you can collect only $500 for those same 100 shares. Of course you LOST money.
Your 'entry price' is completely irrelevant. Your stock was worth $1,000. Now it is worth $500. That's a loss of $500.
It doesn't matter whether you paid $2 per share, $10 per share, or $100 per share. It was worth $10. Now it's worth $5.
When you say you have 'not lost money,' you are saying that you do not have a 'realized loss.' You do not have a loss that is recognized by the Internal Revenue Service, or IRS (USA). Thus, you cannot deduct that loss from your income. But, it is a real loss nonetheless.
This is a blind spot that you share with the vast majority of investors. They believe it's not a loss unless it's sold.
When you own a stock and it declines in price, you lost money. Past tense.
The money is not in your brokerage account
The money cannot be withdrawn or spent
The money cannot be used for margin
How can you convince yourself that its not lost?
So one of three things will happen, right?
1.My stock gets called away at the strike price plus I keep the premium.
2.My stock does not get called away and I keep the premium.
3. I have only lost money on a stock when I sell it and that depends of course on my entry point.
MDW: #1 and #2 are correct. You keep the premium. Your stock either gets called or it doesn't.
As to #3, in my opinion, don't have to sell the stock to incur a loss. You lose money when you decide to write a covered call – instead of selling the stock – and the stock price tumbles.
The price you paid for the stock (yesterday, or last month, or 20 years ago) is irrelevant.
I am very glad you asked these questions. It brings up a situation in which I disagree vehemently with 'common knowledge.'
"I only lost money on a stock when I sell it."
As far as the Internal Revenue Service is concerned your statement is true. They don't consider it to be a loss until the trade has been closed and the loss becomes 'realized.'
In the real world that is utter nonsense.
Sure, the stock can rally and return to the price at which you bought it. That would eliminate the loss.
But so what?
Any stock can move from today's price to a higher price. If that happens, you MAKE money. Well it's the same with a stock you already own. If it moves from today's low price to a higher price, then you earn money from that position (starting from today). At some point, that gain may equal today's loss – and when that happens you have broken even.
But none of that matters. As of today you have lost money. To me, it's wrong to say: 'I am currently losing money.' You lost money. If the stock rallies, then you can look back to today and say 'I made money.'
Today your account is worth whatever it's worth. Your objective is to make it worth more tomorrow. And more the next day. The price you paid when buying an asset does not count. Today's price counts. You can hold or sell. You are not locked into the trade forever.
Today, and every day you can sell your assets at current prices. When you choose not to do so, it's exactly the same as if you made a decision to buy every asset in your portfolio (commission free) at its current price. That's the reason the original price that you paid does not matter – except to the IRS.
It's ignoring reality to think the way you do. And the vast majority agree with you. And I'm in the minority.
Even the government got into the act by allowing insolvent banks to avoid marking their assets to the market. That means the banks got to pretend their investments were still worth the original cost and that they lost no money. The banks were allowed to play make-believe and pretend they were solvent when they were insolvent – and should have been forced into bankruptcy.