The Problem With Covered Calls as an Investment Strategy

I received a funny email today from Bernie Schaeffer of Schaeffer's Investment Research. The subject was "Maintain speed in a falling market - for only $195". Personally, I would not pay $195 to maintain speed in a falling market. To slow down or even reverse in a falling market would be worth paying for, but you can maintain speed for free.

Bernie Schaeffer's particular shtick is options, momentum chasing, and swing trading. The email opens "RIGHT NOW THE MARKET IS UNDER SOME SERIOUS SELLING PRESSURE", and then quickly moves on to Bernie's main message: that you should subscribe to Schaeffer's Covered Call Plus for only $195, an amazing 60% OFF the regular price of $495. But you have to hurry, this incredible savings ends FRIDAY at Midnight.

The service claims to give you a constant supply of buy-write ideas. Buy-write is a strategy of purposefully buying stocks for the purpose of writing call options on them. The net position after writing a covered call is being short volatility. Is this really a good idea in a volatile market?

There are several problems with a buy-write strategy. The problems stem from being short volatility and the transaction costs of an active options strategy.

The main problem is that by writing covered call on a stock you sacrifice all the upside movement past the strike price, while retaining all of the downside. If the volatility is positive and greater than expected, you get the fixed and limited return of the call premium. If volatility is negative and greater than expected, you must keep all the downside, offset by the option premium. Only if the volatility is less than expected and the stock price does not move at all does writing call options give you excess return. This is not a sound or risk-averse investment policy.

The other problem: the transaction costs incurred by frequent trading. A single complete buy-write trade (buy, write, buy to close, get exercised, sell) involves at least twice as much commission as a normal stock trade*. These transaction costs impose a very high hurdle rate.

A simple example: Assume a stock costs $24, and you buy two round lots (2x100) for $10 ($4800). Then you write two three month calls at $25 and receive $288 (10+2*0.75) (Option price for 90 day American call with Implied volatility of %36.44 and risk rate of 5.4%).

So far you have spent $22.5 in commissions to set up the position. Assume that six days prior to expiration you decide to close out the position, and that the stock is still at $24. The option price is now $0.12. Your cost to close is (10+2*0.75+2*12+10) = $45.5. Combined with your opening costs of $22.5, your total cost on the trade is $68. Your annualized hurdle rate on your $4800 investment is 5.6% ((4*68)/4800).

While the example buy-write you ended up with net profit of $220 (for an annualized return of 12.7% net of expenses). However, if things go badly, it gets ugly. That $220 is equivalent to getting an option premium of $1.10. Your downside protection is at most against a 5.3% drop in the stock price (assuming the options expire worthless). On anything more than 5.3% drop, you get not only the losses from the stock's decline but also the addition expense from opening and closing the position. On a single buy-write, the gains are limited to 4.6% of your investment ($265.5/4800), while the losses are limited to $4,534 (94.4% of your investment). Actually, the gains can be even further limited, because of the cost of getting assigned and exercise.

If the best you can do is gain 4.6% and the worst is lose 94.4%; then in the long run you must lose. And if you can consistently beat a 5.6% hurdle rate, the world of hedge funds awaits you.

Every time the stock market gets stagnant, volatile, or trends downward some huckster comes along promoting covered calls as the universal cure.

* A complete buy-write involves 1.5 times normal commission if the option expires worthless, meaning that the final close of the stock is less than strike + $0.25.

Comments

[Fred Thomson:]

This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and WILL BEAT STOCK IN ALL BUT THE STRONGEST OF BULL MARKETS

Trading costs are another possible disadvantage, but again this can be gotten around by not paying ridiculous amount for trades - try Zecco for goodness sake. I've used them over a year now and they don't have great customer service - but it's is way cheaper.

Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at coveredcallcalculator....

2008 Dec 22 11:54 AM

[User 484858:]

This article only gives half the story. How many times have you purchased a stock without writing a call because you were certain it was going to appreciate substantially? Many times you end up waiting months or even years for the stock to move higher, if it ever does. A proper covered call strategy can make you 2% to 10% PER MONTH, even when the market is declining. I agree that traditional covered call strategies don't work well when the market declines, however there are strategies that can offer significantly more downside protection. The end result allows you to grab great short-term returns and compound them over time instead of waiting for the stock to appreciate in the future. This amounts to a safer, more stable investment plan instead of just buying, holding and hoping.
www.rebuildingmyfuture...

Sep 11 11:05 AM