Covered Calls Are NOT a Conservative Trade

[OlmsteadOptions 10]

Dr. Edward Olmstead, Professor, Northwestern University

Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies

 

One of the first strategies that someone new to options hears about is the covered call trade. Frequently, this strategy is touted as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be made in a retirement account because it is “conservative.”

 

Unfortunately, this description of covered call trades as conservative is highly misleading. Ask those same brokers who only allow covered call trades in retirement accounts how they feel about selling naked puts. They will explain how that type of trade is much too risky to be allowed in a retirement account. Well, at least they got that part correct ---- selling naked puts does involve significant risk. The truth is that a covered call trade has exactly the same risk and reward characteristics as selling a naked put. More about this later.

 

In its simplest form, the covered call trade requires that you own 100 shares of stock. Then you can sell one call option contract with a strike price that is above the current stock price. In this situation, the call that you sold is said to be “covered” by the stock that you own. If it happens that the option is exercised, your brokerage account possesses the stock that must be made available for sale at the strike price. The cash received from selling the call is yours to keep no matter what happens.

 

Here is the idealized description of what happens when the call option expires. If the stock price is above the strike price of the call at expiration, your stock will be called away for a price that is presumably higher than your original purchase price ---- you have made a profit on the price increase in the stock and you also have the cash received from the selling the option. If the stock price is below the strike price of the option at expiration, then the option expires worthless and you keep your stock ---- you again have the cash received from selling the option, and you are free to repeat the process by selling another call in the next option cycle. As you can see in this idealized version, the covered call trade has the potential to generate regular profits by repeatedly selling call options against stock that you own.

 

Unfortunately, the covered call trade is not nearly as straightforward as the idealized description would suggest. Stock prices undergo considerable fluctuation over time and, all too frequently, the stock price on the expiration date will be either well above or well below the strike price of the short call. Both scenarios present a difficult decision going forward.

 

If the stock price is much higher than the strike price of the call at expiration, you may be reluctant to give up your stock at a price that is well below its current level, and thus forego any future gains in the stock price. The only alternative is to buy back the short call for a significant loss in order to continue holding the stock. If the stock then fails to perform as expected, it may be quite difficult to make up for the loss incurred from buying back the short call.

 

If the stock price is much lower than the strike price of the call at expiration, you keep the stock, but you are faced with the challenging decision of which call strike to sell for the next option cycle. If you sell a high strike in order to give the stock price room to move up, the cash received from the sale may be miniscule. On the other hand, if you sell a strike nearer to the current stock price in order to receive more cash, you lose the opportunity for the stock to regain all of its lost value.

 

Now let’s get back to comparing a covered call with selling a naked put. To see that these two trades have the exactly the same risk and reward characteristics, examine cases in which the stock price at expiration is either above or below the strike price of the option. To make things definite, consider a specific example.

 

Covered call: With XYZ at $53, you buy 100 shares of stock and sell one 55 call option for $2.0 per share. This means that you have equivalently purchased 100 shares of XYZ for $51 per share. If the XYZ has fallen to $40 per share at options expiration, you will have lost $1100 on this trade. The maximum reward that you can receive on this trade is $400, which occurs when the stock price exceeds $55 at expiration.

 

Naked put: With XYZ at $53, you sell one 55 put option for $4.0 per share, which pays you $400. If XYZ has fallen to $40 per share at options expiration, the option will be exercised and you will be required to buy the stock for $55 per share. Subtract the $400 you received and your loss on this trade will be $1100. The maximum reward occurs when the stock price exceeds $55 at expiration and you get to keep the $400 received from the sale of the put.

 

If you are going to do covered call trades, then be aware that it is not a conservative trade and be prepared to make a challenging decision when the options expiration date arrives. Here are some suggestions for handling covered call trades:

 

1. Since almost all of your risk is in what you paid for the stock, focus your attention on the stock price and to a much lesser extent on the option price. Decide on an appropriate stop loss price for the stock, and if it falls to that level, protect the major portion of your investment by selling the stock and buying back the call. Do not hang onto to a falling stock in order to collect an extra $.50 per share from the short option.

 

2. When deciding upon the strike price of the call that you are going to sell, make sure it is a price at which you will feel comfortable in giving up your stock if necessary. If your goal is to keep your stock under all circumstances, then select a higher strike price. If you are willing to sell your stock closer to its current value, then pick a nearby strike price to bring in more cash.

 

3. Do not sell a call with an expiration date too far out in time. Those juicy premiums in the longer-term options are tempting, but you will generally do better by selling the front month call. In today’s volatile market, a stock can have big moves (up or down) in 4-8 weeks. By selling near term options, you will be better placed to make an adjustment when the expiration date arrives.

 

4. Do not be greedy. If the stock price is above the strike price at expiration, take your profit and move on to a new trade. Avoid buying back the option for a loss unless you have a very compelling reason to do so. If you buy back the option for a loss and then the stock price subsequently collapses, you will have compounded a loss on the option with a loss on the stock.

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Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com