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I’m a swing trader of momentum stocks with a holding period of anywhere from a few hours to a few months. I run a number of screens to locate the strongest/weakest stocks out there, using technical analysis to determine my entries and exits. Trying to calculate the intrinsic value of stocks in... More
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  • The Many Pitfalls Of Selling Covered Calls 6 comments
    Feb 24, 2012 5:42 PM

    The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

    Do You Want Fries with Your Covered Call?

    A covered call is one of the simplest option trades, which may be one reason that in recent years some brokers have reported that as many as 85% of traders are using the strategy. However, just because it is popular does not necessarily imply that it is profitable. The performance of one mutual fund that utilizes covered calls, Eaton Vance Risk Managed Equity Option (MUTF:EROAX), reveals the very real possibility of potential losses. While the 1-year performance of the S&P 500 is nearly flat, the funds shares are down nearly 7%.

    Why would 85% of traders be using the same option strategy unless it was highly profitable? The short answer is that covered calls are the 'fast food' of the options market. They are quick, easy trades that are simple to understand. Most often, these trades are only open for a few weeks at a time, so a trader can get in and out without a long-term investment. Given the potential for speedy profits, and the huge volume of advertising dedicated to luring new traders, their eventual popularity was likely inevitable. In good times they are coveted by many. Sellers get a decent income while the call buyers get great percentage returns, and brokers cash in on the commissions without taking on the risks inherent in some option trades.

    Those not familiar with covered calls might be surprised to learn just how simple it is to trade them. Almost any trader who wishes to do so can get paid to buy practically any stock or ETF he chooses. With a few clicks of a mouse, the trader buys 100 shares of stock and then sells a call option. Most commonly, the trader agrees to hold the stock until the third Friday of the month at which time the buyer is expected to take possession.

    Simple and fast? - Yes.

    Profitable? - Not so fast.

    In reality, selling covered calls can be as unfulfilling as selling burgers at a fast food restaurant. The call seller is doing all of the work; buying the stock, holding it for a period of time, and giving away most of the profits, in return for a small fee. While the odds are strongly in favor of the seller generating income during good times, the loss of income during tough times can be devastating. A market correction or a bear market will eventually occur. When it happens not only does the potential income diminish or disappear all together, but the call seller can be left holding a stock that can not be sold without taking a substantial loss. During strong rallies, covered call sellers may feel as if they are working for minimum wage while everyone else is getting wealthy. When the market moves sideways, they may become a nervous wreck waiting for expiration day. When the market reverses, they may feel as if Wall Street has just ordered dinner and then stuck them with the bill.

    Selling covered calls for consistent profits is a challenge even for professional managers of mutual funds, so what chance does an individual trader have? Probably not much, at least over the long term. The strategy might best be described as entry-level work in the field of options. Learning how to trade it can be a valuable first step in beginning a career; however, it is seldom the final step. While there is an almost endless demand for new traders, the pay is rarely as dependable as other option techniques. Turnover is high, and the working conditions are frequently stressful. Despite the prospect of getting paid to trade stocks, a trader who seeks to retire from the workforce by exclusively selling covered calls may ultimately find himself thinking that he should be asking his customers, "Do you want fries with your covered call?"

    Questions or comments about covered calls or any other option strategy are encouraged. Feel free to enter them in the comment section below.

    Related Options Posts By Chris:

    The Whipsaw Generator

    Everybody's Trading Options

    Will Governments Manipulate Options Market in 2012

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Comments (6)
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  • flash9
    , contributor
    Comments (3752) | Send Message
    Writing options is a form of cutting your profits short and letting your losses run.
    25 Feb 2012, 10:10 AM Reply Like
  • dancing diva
    , contributor
    Comments (2752) | Send Message
    Jeff - a few comments. The chart shown above is not the eaton vance risk managed options fund, but an eaton vance closed end fund that pays a monthly distribution. Of course that would fall in a flat market.


    But the eroax did fall as well. It has a very high mgmt fee and was obviously mismanaged (and a load of 5.75% - ouch!). But more importantly, according to their fact sheet:


    "Fund managers write S&P 500 Index call options to generate premium income and purchase index put options to help cushion returns in down markets. Fundamental research governs the buy/sell decisions made at the individual stock level. Management seeks to reduce the impact of taxes on income and gains."


    So they were not only selling calls but buying puts. And I imagine, did a poor job of it, probably buying some very expensive put protection after the market fell. Note also, the fund price is below its March 2009 low, while the S&P more than doubled. Obviously something is very wrong there, and to use them as an example of why selling covered calls is bad.


    Like any other tool, you have to know how to use it. You could put a nail in a board with a wrench, with difficulty, but it's far more efficient to use a hammer. Options are the same. A few useful hints to using covered calls:


    1. Never sell a call with very low volatility. You gain little and risk getting a stock called away on a rally.
    2. In a rallying market, never sell calls on your entire position, and then only if you are willing to lighten up at that level.
    3. Never sell calls after a hard market correction. Usually, but not always, the stock market bounces back in short order.
    4. If volatility is sufficiently high and you want to capture some income, sell both a call and a downside put. This way if the market continues to rally and your stock is called away, at least you've made more money.


    I use selling calls to generate more income all the time. Rarely has an option been called away. And on the couple of occasions that occurred, it was near a near term top in the stock.


    An example of a stock I've recently partly covered is Macy's. I've been long awhile and after earnings sold ( on about 40% of my position) the January 40 calls for $3.10 (stock was around $37 at the time - and it closed there Friday). I still like Macy's potential, but at $37 it's no longer very undervalued. When I sold it the 40 call on Wednesday the implied volatility was 32% which I judged to be fairly high. If the stock is near $40, I've doubled my return at options expiration. Only if the stock rallies more than $6, or more than another 16% over the next 11 months, will this be a poor play. Can it happen? Possibly. Will it happen? Doubtful. And I'm partly protected if Macy's falls. And btw, Thursday I sold a small quantity of Macy's $30 puts for $2.25 - roughly 38% volatility.


    Note, the implied volatility of the call option is an important consideration for covered calls. Had it been substantially lower (Rost is about 24% for the equivalent option, IBM around 19% , P&G an even lower 14%) I wouldn't have bothered.


    Note - why so many people complain about options is that they typically buy them. The trouble is an option is a wasting asset, with time decay making losses almost inevitable unless a stock is quickly moving higher. Option sellers use time decay as their friend.
    25 Feb 2012, 04:08 PM Reply Like
  • OptionScientist
    , contributor
    Comments (2) | Send Message
    dancing diva - You make some excellent points, however Jeff isn't really the one to blame because I was the contributor of the original post.


    Yes, EROAX was probably not the best choice of an example of covered call mismanagement. It is sort of like blaming an auto accident on the driver's use of a cell phone and ignoring the fact that the car was traveling at over 100 mph.


    I also agree that covered calls are a valuable tool, but only under the correct conditions. With volatility currently being very low compared to last year's levels, now is not a great time to sell them unless the underlying stocks are chosen very carefully.


    It seems that your success with covered calls, as my own, is the result of avoiding them when market conditions are not favorable. There are times when I sell options and times when I buy them, but I would never confine myself to any single strategy.


    Christopher Ebert
    27 Feb 2012, 09:41 AM Reply Like
  • spielman
    , contributor
    Comments (43) | Send Message
    I am a novice at covered calls (probably written < 10 in my entire life). However, they have all worked, which may be more luck than skill.


    Has anyone pursued a strategy (I'm sure they have) of using two similar stocks (VZ and T as an example) and then: Writing covered calls on VZ and writing writing naked puts on VZ? If you carefully move around the dividend period, it seems to me that you could collect dividends while earning some call and put income at the same time. If you got called out of VZ, you could get back in by purchasing T and be back in the game, repeating the strategy by just reversing the stocks (naked puts on VZ and covered calls on T).


    I realized these stocks probably have low volatility. But would this strategy generally work? I would love to see if anyone has back tested it.
    4 Mar 2012, 01:54 PM Reply Like
  • OptionScientist
    , contributor
    Comments (2) | Send Message
    Regarding the VZ/T covered call and naked put strategy: this is definitely a viable trading plan, and it will likely work about 60% of the time. However, the few times that it does not work could prove devastating.


    As strange as it may seem, it should be noted that covered calls are almost identical to naked puts. In both cases the writer is exposed to the entire downside of the stock price with only the premium to offset the loss. Dividends do alter the equation slightly, but call premiums are discounted prior to an ex-divided date. The covered call writer gets a smaller premium but keeps the dividend while the call buyer pays a smaller than normal premium but is not entitled to the dividend. The dividend also tends to lower the stock price slightly, and that also lowers demand from call buyers.


    The market has been very conducive to both covered calls and naked puts for several months now. As stock prices have generally trended upward, covered calls have tended to be assigned at a profit while naked puts have expired worthless. But when the market changes, like it did in the summer of 2011, an entire years worth of profits can be wiped out in a few days or weeks.


    Also, the low volatility of the broader market has cut option premiums in half in some cases when compared to a few months ago, and VZ/T have both realized similar changes. Any sudden increase in volatility could also be a danger to covered calls or naked puts.


    Given that the market has yet to make a major correction in 2012, I would personally be more comfortable waiting for a dip and then selling covered calls or naked puts when premiums have been inflated by the fear generated by the pullback in prices.


    While I have not run back tests on these specific stocks, I would suspect that they would have performed similarly to those on a broad ETF such as SPY. For 2011 the strategy would likely have taken a big hit from July to August but still managed to end the year with a small profit.
    5 Mar 2012, 11:47 AM Reply Like
  • chanthirani
    , contributor
    Comments (467) | Send Message
    I prefer writing ITM covered calls. The profit is not as great as OTM covered calls but there is greater downside protection in case of a dip.


    dancing diva has also highlighted some of the other risk management techniques that I use.
    24 Oct 2012, 11:14 AM Reply Like
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