You are not using options? II. Is covered call writing for you?

Recent commentary on this blog suggests that it is important to examine option strategies from more than a single perspective.

As a true believer that options can work wonders as risk-reducing investment tools, I often lose sight of the fact that most investors don’t use options and have a very negative opinion of them. When writing about a given strategy – or any options related idea – it’s important to consider why non-option users don’t want to be bothered with options.

Definition

A covered call position consists of owning 100 shares of stock and selling one call option. In simplistic terms this means that the stock owner has collected a cash premium and in return, accepts the obligation to sell that stock – with certain restrictions – to the call owner. These are the basic requirements (the nitpicker can find things that are not exactly accurate, but they are good enough to clearly define the option contract.

  • The stock is to be sold at the strike price of the option, and at no other price
  • The decision to purchase must be made before the option expires
  • The decision (whether to buy the shares) is made by the option owner
  • The option seller plays no role in the decision
  • Once the option owner exercises the call and the option seller has been assigned an exercise notice, the transaction is final and cannot be reversed

Risk

If the stock undergoes a severe price decline, you, the covered call writer can incur a large loss. The loss is almost as large as that of any other stockholder, but by writing the call, your loss is reduced by the premium collected.

Thus, there is substantial market risk, when the market declines.

Sacrifices

Writing covered calls is a simple trade. The writer gains something in exchange for something else.

The covered call writer accepts a cash payment upfront. That’s referred to as the premium, and is the price paid by the call buyer to the call seller. That cash premium belongs to the option seller and is his/hers to keep forever.[NOTE: If you decide to repurchase that call option, you pay the then current premium. That has nothing to do with the premium that you collected when you sold the option]

The call buyer gets something intangible in return for the cash payment. He/she gets to collect every penny of the stock option value – above the strike price. If the stock is not trading higher than the strike price when the market closes for trading on expiration Friday, then the option has no value and expires worthless. The option seller’s obligations are canceled.
seFor example, if the option has a strike price of $40, and if the stock is $43 when expiration arrives, then the option owner has the right to buy stock at $40 and sell it at $43. In practice, the call owner is better off selling the call option and not bothering with the exercise process. The call owner, now the exerciser, then sells stock at the higher price, keeping every penny of the difference.

Without the call sale, those profits would go to the original stockholder. However, by selling the call option, those profits have been transferred to the call owner.

Note: The option owner does not have to hold that option until it expires. He/she may sell it at any time. More than that, it is almost always better for the call owner to sell, rather than exercise that option.

Benefits

Stock prices do not always rise

When you write, or sell, an option that is out of the money (the strike price is above the current stock price), most of the time the option expires worthless.

Most of the time you earn extra profits (or reduce losses) when writing covered calls. But not every time. Part of the time the call buyer makes money that could have been yours. However, we never know when stocks are going to rise and when they will not.

By writing the call option, you agree to accept a cash payment – now – and agree to let someone else have profits above a certain price point.

This is a simple agreement. Many people find it attractive. It works on the principle that a bird in the hand is worth two in the bush. And it’s perfectly acceptable to believe in,and practice that way of thinking.

It’s also reasonable to seek huge profits – that do occur every once in awhile. It’s okay to take your chances on owning the stock without a hedge. After all, you did research when deciding which stock to own, and if you believe that your research will pay dividends, if you believe that you have a special talent for picking winning stocks,then of course you will not want to give up those potential profits. You will not write covered calls.

However, if you believe, as I do, that the ability to outperform the market with stocks election is limited to a small minority of investors and traders, then you may feel that accepting the option premium that comes your way when writing covered calls is beneficial.

There is no right or wrong here. There is only the decision: Do you want to trade possible profits – profits that may never arrive or profits that may be huge – for the option premium that comes when selling calls? It’s a personal decision. It depends on your reasons for investing. Some people seek steady growth, others seek to get rich quickly.

The purpose of this post is to clarify the situation for investors who don’t really understand how this strategy is supposed to work and what the covered call writer stands to gain or lose. The rest is up to you.

Please note: I believe there are less risky methods that involve adopting similar strategies. Those come with less risk and less reward. Again, they are not for everyone.

I believe the following is obvious. Nevertheless, please understand that nothing in this post should be taken as a recommendation to adopt this, or any other option strategy. I am presenting my opinion because it may prove to be helpful when it comes to using options. The final decisions are yours alone. Do not thank me for profits earned nor blame me for money lost.

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6 Responses to You are not using options? II. Is covered call writing for you?

  1. Jeff 04/13/2011 at 9:58 AM #

    Nice explanation Mark. I have been a covered calls investor for the past 30 years and have found that it can provide somewhat better overall returns than a basic buy-and-hold strategy and with the added benefit of about 30% less risk. I am surprised that more investors don’t utilize covered calls, but I think the primary reason for this is that it does require more time to manage (compared with buy-and-hold), and many investors aren’t motivated to invest more of their time to learn how to exploit investing edges via covered calls in order to achieve modestly better returns. Fortunately, the returns from covered calls enabled me to retire at age 57 even though I never had a job above Manager level. My wife and I purchased and live in a very nice home, and raised two daugthers (including paying for all their college expenses). My wife worked about 20 hours per week in relatively low $/hr jobs during most of those years.

    Thank you covered calls,
    Jeff

    • Mark D Wolfinger 04/13/2011 at 10:21 AM #

      Jeff,
      I appreciate that you shared your success story.

      Jeff publishes a blog devoted to covered call writing.

    • Wayne 04/13/2011 at 10:21 AM #

      Jeff,
      In your 30+ years of experience as a covered call writer, do you spend a lot of time doing technical analysis on your selected stock, like reading candlestick, bollinger band, etc? Thanks
      Wayne

      • Jeff 04/13/2011 at 10:52 AM #

        Wayne,
        No. I believe in fundamental analysis, not technical analysis. I fully concur with two great investors’ views on technical analysis:
        (1) “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” — Warren Buffett; and
        (2) “Charts are great for predicting the past.” — Peter Lynch
        Jeff

  2. Robert D. 04/13/2011 at 7:06 PM #

    Mark,

    Consider a trader who only writes covered calls, and realizes a given return over some time period. Would it be accurate to say that this trader would have earned more money (with all other factors being equal) by writing cash secured puts instead? I’m thinking primarily about savings on commissions, but I’m not sure how dividends would figure into this.

    Thanks much,
    Robert

    • Mark D Wolfinger 04/13/2011 at 8:14 PM #

      Robert D,

      I hate to qualify my reply but:

      a) If you are talking about the equivalent put – i,e., same strike and expiration date – then the difference should be pretty small.

      b) However, there is this consideration: The CCW is probably selling OTM calls (although you did not ask about that) and if that trader were to sell puts, there is a good chance that they would also be OTM. If this scenario, there is evidence that put writing does better.m And there is evidence to support that point of view (at least there is evidence for the S&P 500 index). Compare the returns of BXM (CBOE buy-write index) and PUT (CBOE Put-write index).

      Dividends should be priced into the put premium (not the full dividend, but an allowance for the fact that the stock is expected to trade lower by the amount of the dividend). If priced efficiently the dividend makes no difference.

      But selling puts with a lower strike does two things that have helped PUT outperform BXM” The put sold has a higher implied volatility. The covered all writer has a more bullish position, and that has added small edge. Obviously this varies from one time period to another.

      The bigger factor is that the BXM sells the first OTM call and PUT sells the first OTM PUT. There’s not much difference in the strike prices of the options sold when the index is ‘expensive’ [currently 1,300].