Writing covered calls

[Delawaredave]

OK, so Thanksgiving with my sister-in-law's famly - someone can't stop talking about the "can't lose" moneymaking strategy of writing covered calls.

Anybody play with this strategy ? (I'd guess folks on this board avoid these mechanics).

My little experience with options and arbitrage stuff is that the market prices these things pretty well - and that this is more "gambling" than "investing".

But I guess if there's a stock you're holding for dividend reasons or close to your sell target, this might be a way to add a little gain from it.

I suspect the food I got yesterday was better than the financial advice....

 

[youbet]

There is no simple answer for your question regarding covered calls. Many well versed students of the game use the strategy successfully. But, like every investment tool, there are pros and cons.

Head to the library and pick up "Options as a Strategic Investment" by Lawrence G. McMillan. This is a 1K page text, but don't be overwhelmed. The first few introductory chapters are what you're interested in and will give you an appropriate overview without bias. If you're still interested, well you've got many hundreds of additional pages to keep you entertained!

I believe writing covered calls based on one of the "systems" currently being sold via infomercials or based on someones's opinion might be amusing but probably not profitable.

 

[FIRE'd@51]

The funny thing is that most people who write covered calls will tell you that they would never sell a naked put, yet the two strategies are functionally equivalent.

 

[Anansi]

You can do a lot of "interesting" things with options, some of which are very risky, most of which I probably don't understand and definitely don't do, but covered calls are really fairly simple and low risk. Definitely a conserative use of options.

Worst case, you end up selling a stock (at a futue date) that has run up for less than its price at the time. But you do get the (presumably) higher option price and did get paid something when you sold the option so you didn't really lose anything. And if the stock doesn't go up enough to meet the option price, then everything you got for the options (less fees) is profit.

Not too complicated and you probably can make a few dollars.

 

[FIRE'd@51]

Worst case, you end up selling a stock (at a futue date) that has run up for less than its price at the time.

Actually this is the best case (you get the maximum return that the strategy will yield). The worst case is that the stock goes down sharply, and you participate in the decline (minus the option premium you took in).

 

[Nords]

Anybody play with this strategy ? (I'd guess folks on this board avoid these mechanics).
My little experience with options and arbitrage stuff is that the market prices these things pretty well - and that this is more "gambling" than "investing".
But I guess if there's a stock you're holding for dividend reasons or close to your sell target, this might be a way to add a little gain from it.
I suspect the food I got yesterday was better than the financial advice....

You're right on all counts. I'm not turning on options in my brokerage account until I fully understand how I'll use them. And I'm too busy pursuing other interests to gain that understanding now.

Options always come into vogue during sideways markets with low volatility. Funny how we never heard much about them during the late '90s or 2001-2.

You can probably make just as much money (especially after taxes) by taking credit-card balance-transfer offers and investing the zero-interest loans in short-term CDs.

 

[saluki9]

You're right on all counts. I'm not turning on options in my brokerage account until I fully understand how I'll use them. And I'm too busy pursuing other interests to gain that understanding now.

Options always come into vogue during sideways markets with low volatility. Funny how we never heard much about them during the late '90s or 2001-2.

You can probably make just as much money (especially after taxes) by taking credit-card balance-transfer offers and investing the zero-interest loans in short-term CDs.

I wouldn't go that far. There is no magic in covered calls, and yes the infomercials are correct in that you can "rent" your stocks and get a cash income from them.

That being said, you are still taking all the risk of equity ownership for a smaller cash upside. If that is all you want to do there are several decent closed end funds that will do it for you and kick out a 7-9% yield with no leverage. Nuveen does a bunch of them.

Options aren't rocket science.

 

[brooksr]

I've done covered calls, naked puts and credit spreads. Probably a couple hundred in total and have about broken even.

A covered call is just like a naked put.

A key question is: are you writing calls against long term holdings in your portfolio that you already own to earn some extra income/return OR are you looking for favorable CCs and doing what is called a 'buy-write' which means buying the stock/ETF, etc. just so you can write a CC against it.

If you decide to do buy-writes like I did, you will find the ones with the juiciest returns are also the ones with the most risk. AND, that one loser can wipe out MANY winners.

Two suggestions:
1. Do NOT write CCs on any stock that will have an earnings announcement before the call expires.
2. Do NOT write CCs on any pharma stocks as they are subject to unexcepted price shocks/precipitous drops due to unexpected news events (especially from the FDA).

Brooks

 

[ERD50]

...someone can't stop talking about the "can't lose" moneymaking strategy of writing covered calls.

I'd guess this is due to some radio infomercials I've heard recently. They make it sound like you just take 5% per month and never, never lose.

If you follow closely, I think you discover that they never lose because - they NEVER count their 'losers'! They just say, oh yeah, that stock went down, but we don't include that in our returns because we 'haven't closed the position yet'! Hmmm, I bet your mutual fund would like to do that! They claim you just keep selling calls on it, and rolling them out, and you keep making 'income'.

Well, accounting like that, it wouldn't be tough to find people that have been following their strategy for 6 months and are reporting fantastic returns. A few stocks dropped? No problem, we are still selling calls on them - just look at all the money we made on our winners. I'm surprised they can say stuff like this on the air.

As other pointed out, high premiums mean high risk stocks. One loser wipes out many winners. I'm doing it now, I think it can work out, but it's not magic, and I sure have not made any 60% a year.

They sure make it sound good. I'm glad I know better.

-ERD50

 

[MasterBlaster]

Covered calls..

As others have suggested you take all of the downside risk for very limited upside potential. That's the short versions of the story.

The longer version goes something like - Yes maybe you can make a percent or two (after commsions) off of the stock with an option expiring in a month or so.

But we expect the stock to average about 10-12 percent a year anyway don't we That's the long term avarage of the S&P500 isn't it So we expect 1 or so percent gain on a stock anyway. Do covered call options rally beat that ??

So you are taking all of the downside risk for essentially no upside gain. Yes maybe you can catch a few breaks before your option excercises. But so what ?

I have never understood the value of these things when looked at under the light of day.

So gambling == covered calls sounds about right in my book.

If there is some real, long term value in these things please enlighten me

 

[Anansi]

Actually this is the best case (you get the maximum return that the strategy will yield). The worst case is that the stock goes down sharply, and you participate in the decline (minus the option premium you took in).

Well, there are actually lots of worse things that could happen - you could get run over by a truck for example - but it seemed reasonable to limit the discussion to things caused by selling the option. The stock going down would have happened in any case.

In any case, you certainly aren't going to make windfall profits on covered calls, but they aren't particualrly risky.

 

[samclem]

Isn't all option trading of any kind a zero sum game (ignoring the sizeable commissions and other costs)? That is, for every individual who makes money, there is someone who loses the exact same amount of money. This is different from most investments (equities, RE, bonds, etc), where it is possible for everyone to make money.

If I've got this right, then I'd classify options trading as being much closer to betting than investing. That doesn't make it bad or evil, and it doesn't mean you can't do well at it (there are some professional handicappers who make money at the track). It just assumes that you need to be sufficiently smarter than the average bear to cover the spread. That doesn't sound like a game for amateurs.

 

[LOL!]

Over the past few years, I have sold a number of covered calls. I would not denigrate it as much as folks have in this thread, but the strategy is not the panacea that infomercials suggest it to be.

I have used it when I am ambivalent about selling a stock. I will write a call and if the stock gets called away, I have booked the call premium plus the stock gain. If the stock doesn't get called away, I have booked the call premium and can do the strategy next month.

You can use MS Excel and the stock quote plug-in to find good options plays on the stocks you own. You can plug in all your commissions to see if it makes sense. It turned out for me that in a 15 stock portfolio, a good play (5-10% out of the money stirke price, 1-2% call premium) occurs maybe 6 times a year. Generally, I need to have 10 calls (1000 shares of underlying stock) to make it worthwhile.

The major downside of the strategy was you had to be watching almost all the time because some plays are good for a fleeting hour or so. The idea that you don't participate in a stock's rise past the strike price is true, but you have accepted that when you sold the call. That is, I have sometimes been happy my stock has been called away. A few weeks later when the stock trades below that selling point, I may just buy it back.

 

[MooreBonds]

Isn't all option trading of any kind a zero sum game (ignoring the sizeable commissions and other costs)? That is, for every individual who makes money, there is someone who loses the exact same amount of money. This is different from most investments (equities, RE, bonds, etc), where it is possible for everyone to make money.

In a situation of
Person 1 sells covered calls
Person 2 buys calls
and the stock, at most, rises to (exercise price + option premium), it's a zero-sum game.

In a situation of
Person 1 sells naked calls
Person 2 buys naked calls
and the stock closes at any price, then it's a zero-sum game.

If, however, the stock rises above (exercise price + option premium) in the first scenario, then technically, it's a net overall gain, since Person 1 gains by selling the stock above the current price, and they gain the option premium. Person 2 also gains because the current stock price is above his net cost (exercise price + option premium).

A similar exercise can be made for puts.

In a sideways market, covered puts/calls are zero-sum gains. Naked puts/calls are always a zero-sum game. But in a rising/declining market, there is a net gain/loss overall.

 

[Alex]

As a former securties broker, I can state with absolute certainty: 99% of investors will lose money in the long run with options or commodities. Covered calls are a 'logic play' that the brokers use to 'rope in' average investors who would normally never consider these overhyped strategies. It all 'sounds' so good! The brokers/salesmen/hucksters are really hoping that they can get you hooked on more complex options strategies that generate lucrative commissions for the brokerage. Buyer Beware.

 

[FIRE'd@51]

In a situation of
Person 1 sells covered calls
Person 2 buys calls
and the stock, at most, rises to (exercise price + option premium), it's a zero-sum game.

In a situation of
Person 1 sells naked calls
Person 2 buys naked calls
and the stock closes at any price, then it's a zero-sum game.

If, however, the stock rises above (exercise price + option premium) in the first scenario, then technically, it's a net overall gain, since Person 1 gains by selling the stock above the current price, and they gain the option premium. Person 2 also gains because the current stock price is above his net cost (exercise price + option premium).

A similar exercise can be made for puts.

In a sideways market, covered puts/calls are zero-sum gains. Naked puts/calls are always a zero-sum game. But in a rising/declining market, there is a net gain/loss overall.

When people say options are a zero-sum game, they mean the options by themselves. The only reason your example appears to have two winners is because you have introduced physical shares of stock into the equation (the covered call writer bought stock). The options still add to a net gain of zero (before commissions). This is true for any derivative security since the long position is created by someone else taking a short position. The sum of the derivative returns will always add to zero (before commissions).

 

[ERD50]

Isn't all option trading of any kind a zero sum game

Not quite, because the underlying stock is a part of the overall 'game'.

You could say selling insurance (equate this to selling puts), or selling lottery tickets (equate this to selling calls ), is a zero-sum game. But insurance companies and casinos make money. But they make it a little at a time, many times over.

When you sell options, you put up the stock or cash at risk. You also have a limited up-side. You trade this for a known premium. You get that premium, even if the stock stays flat.

You will not get rich selling options, but I do believe the odds are slightly in your favor. My view on that is, since the seller of the option is putting up the money or stock as collateral, the market will dictate that they be paid for taking that risk. It just makes sense to me that the market must provide some reward for taking that risk. Just like you pay a premium to an insurance company or a casino.

The person buying options isn't putting up anything beyond the option price and they are not accepting any added risk, and they have a chance of a large reward. There must be a price to be paid for that, in the long run. That 'price' goes to the seller (outside of fees).

So, I think option sellers can make money, but it is no get-rich-quick scheme. I think option buyers have the deck stacked against them.

ERD50

 

[Delawaredave]

I have used it when I am ambivalent about selling a stock. I will write a call and if the stock gets called away, I have booked the call premium plus the stock gain. If the stock doesn't get called away, I have booked the call premium and can do the strategy next month.

Great comments by all - thanks. Sounds like buying a stock primarily to write calls on is nuts.

Writing calls on a stock you're holding anyhow and are "on the fence" on seems like it might have some small upside.

 

[ERD50]

Sounds like buying a stock primarily to write calls on is nuts

Maybe just semantics here, but I don't think it is nuts at all to buy a stock primarily to write a call on.

I think it *is* nuts to buy a stock that you would not want to own at the end of the contract period - if it is not called away, you will own it. That has to be part of the plan.

Now, I have done buy/writes (or cash covered puts - same thing) on a stock for *this* month, that I don't want to hold *next* month (maybe because an earnings report or other news is due). But, my plan from the start is to sell it immediately (at whatever price it is at), if it is not called from me. If you are not comfortable with that, don't do it.

-ERD50

 

[free4now]

It seems like covered calls are a bet on low volatility... they will generally make money when volatility is lower than the market expects, and they will lose money when the volatility is higher than the market expects.

So to come out ahead in the long term with covered calls you need to be better than the market at judging what the volatility will be. Since I don't pretend to have any special powers in that area, I stay out of this game.

 

[retire@40]

I never bought stocks just to sells calls against, but I did sell covered calls on stocks I was looking to sell anyway. As soon as I bought a stock, I would pick a selling price. When the stock got to my selling price, I would sell a call against it at a higher price one or two months out.

The one stock I did a lot of covered call selling in the 90s was Staples. I made more money selling covered calls than I did on the eventual sale of the stock.

In fact, I got rid of most of my stocks with covered calls as I moved away from stocks and reinvested into mutual funds.

I could never figure out why I never got a 1099 for the covered call sales.

 

[ERD50]

I could never figure out why I never got a 1099 for the covered call sales.

Sorry to break the news, but you still owe taxes on the gains.

Yep, you get a 1099 for stock sales but not option sales, or sale of your house, either. But you are still obligated to pay taxes on them, if they are owed. Trying to figure out why is an exercise in futility - these are taxes we are talking about.

The feds sure make paying your taxes correctly a pain.

Here's the fun reading part:

http://www.irs.gov/publications/p550/ch04.html#d0e12992

-ERD50

 

[retire@40]

Sorry to break the news, but you still owe taxes on the gains.

I knew the news and I paid all my taxes on all option gains since the early 90's, just don't know why the investment companies don't send out 1099-B forms for option sales as they do for stock and mutual fund sales.

 

[ERD50]

... just don't know why the investment companies don't send out 1099-B forms for option sales as they do for stock and mutual fund sales.

I agree it seems strange. Why one transaction and not another?

Maybe the better question is *why* stock sales are sent to the feds? Most other transactions are up to the individual to report.

My preference would be to not tax any of this at all, but lacking that, I wish they would at least be consistent. Why track stock sales, but not the buys? I think it just comes down to our tax system being a hodge-podge of various laws passed at different times with no overall strategy or guidance. JMO.

-ERD50

 

[whitestick]

I'd guess this is due to some radio infomercials I've heard recently. They make it sound like you just take 5% per month and never, never lose.

If you follow closely, I think you discover that they never lose because - they NEVER count their 'losers'! They just say, oh yeah, that stock went down, but we don't include that in our returns because we 'haven't closed the position yet'! Hmmm, I bet your mutual fund would like to do that! They claim you just keep selling calls on it, and rolling them out, and you keep making 'income'.

Well, accounting like that, it wouldn't be tough to find people that have been following their strategy for 6 months and are reporting fantastic returns. A few stocks dropped? No problem, we are still selling calls on them - just look at all the money we made on our winners. I'm surprised they can say stuff like this on the air.

As other pointed out, high premiums mean high risk stocks. One loser wipes out many winners. I'm doing it now, I think it can work out, but it's not magic, and I sure have not made any 60% a year.

Like others mentioned here, I too have sold several hundred covered calls ( and a number of naked puts as well), and while not wanting to appear as a Troll, I think that the various infomercials are like the ads for cars - you can see an ad for a Kia, or a Lexus. The devil is in the details.
I have followed, sort of, the SIM method, and while the 12 % mentioned is debatable for the S&P, that has been my experience for the so called losers, the ones that go down, you keep selling against the lower prices, and eventually when they go back up (and with a modicum of filtering), they usually all go back up, then you sell them, or not, at the strike price above your average overall cost, and add up all the option premiums and the gain on the stock and calculate your results. I have had the worst ones end up being in the 10-12 % range. The majority are well above 20 - 25 %. Overall has been a bit above 20%. And that includes adding in the uninvested funds as well - in other words, the total stake available.
I have a great skepticism about the infomercials promising 5% per month, as another writer previously stated. As to the commissions, I typically use a discount broker, to keep commissions low, and the total for the year, doesn't appear to be significant in the overall gains made.
JMO and experience.