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.


6 Responses to Writing Covered Calls in 2010

  1. Bill 01/04/2010 at 12:13 PM #

    Hi, Mark. I’m wondering how sensible it is to take a market neutral options position when an index reaches a 20 day or greater high or low. As you noted in your book, it’s the rare trader that can successfully predict market direction (even though we all think we can), but as I look at a probability calculator today for RUT Feb options (RUT currently testing a 20 day high), it computes that the chances of finishing at 680 (a 6% gain from here) are about the same as finishing at 600 (around the 50 day moving average). Recognizing that there can be short term swings dragging prices back to moving averages, even in markets that continue to trend but especially as the index prices reach new highs or lows, here’s your question: how does Mark Wolfinger reconcile what the probability calculator is telling him with what his TA trained eye is telling him?

  2. Mark Wolfinger 01/04/2010 at 1:19 PM #

    I don’t have a TA trained eye. I never use TA – although I may glance at a P&F chart every once in awhile.
    The probability calculator doesn’t consider such things as moving averages etc. (I know you know that.) It just looks at the numbers and does a statistical analysis.
    As a market neutral trader who does not use TA, I know I am supposed to ignore ‘where the market has been’ when trading. But I cannot do that.
    I am afraid to sell put spreads that are anywhere near current levels. I have less fear selling call spreads. Why is that? My trading persona tells me that up and down are equally likely. My risk management persona has me afraid of a market decline.
    For me, opening new positions with new risk is difficult right now. That’s why I am happy to own insurance.
    If you consider 20-day highs (or lows) to be inflection points, perhaps the right play for you is to go long gamma for a short-term trade. Perhaps you can buy a directional kite spread.
    But, not having any market bias on which I want to trade, I’ll just continue with iron condors or double diagonals (have not done them recently) and continue to sacrifice potential profits by owning protection.
    I’m sorry I cannot supply a direct answer to your query. Never having traded, or considered trading, those 20-day highs/lows, I don’t know whether it’s okay to ignore them.

  3. Bill 01/04/2010 at 3:45 PM #

    Thanks, Mark. Hoping I’m not pressing too much here. Regarding your risk management persona, are there clues that you can share which, from time to time, might make you more cautious of a price decline or rise beyond your choice of strikes, changing your comfort level so as to be more likely to buy preinsurance? Or is the occasional concern about a decline or rally more of a gut feeling developed from years of trading? Or do you purchase preinsurance every cycle, no matter what?

  4. imgamekc 01/04/2010 at 6:59 PM #

    One aspect of covered calls you failed to mention was if you were rolling your position out you would also collect any dividends owed due to the actual ownership of the stock. It would increase the returns of any portfolio that used a covered calls on dividend stocks. So not only would it have reduced a less volitive ride, it would have produced income as well above the returns you stated.

  5. Mark Wolfinger 01/04/2010 at 7:31 PM #

    Your questions are fine. In fact they are so good they are difficult to answer.
    1) Right now, I am so busy writing that I have less time to devote to trading. Thus, for now, I always own insurance.
    It’s not true pre-insurance – as described in Rookie’s Guide. Rather it’s a series of kite spreads, bought patiently – when not needed.
    For example, I bought a (bearish) put kite today: Rut Mar 580 P//Mar 550-560P spreads.
    If I were to run out of insurance – i.e., have a risky portfolio, then I would add more protection without waiting for an opportune time.
    2) Nothing makes me more cautious about a price decline than a big rally. Thus, I have been concerned for the past 6 months!
    There’s probably not much benefit to you from this reply, but I have no sense of when the market may tumble or soar. I try, but do not always succeed in being prepared.

  6. Mark Wolfinger 01/04/2010 at 7:38 PM #

    Writing calls on dividend paying stocks is a fine, conservative strategy. And you are correct about the added cash collected.
    But keep in mind that these tend to be less volatile stocks with small option premium. Thus, the dividend may help, but the premium is too small for my style.