In our article on busting options myths, we described four myths bandied about options that we think are misleading and/or suboptimal. In this follow-up, we focus on myths about covered calls. We will discuss these myths in more detail, provide some justification of our criticism and of our new method, and also give you a tool to use with our unusual trading style. (Or we could do it for you.)
We hope this helps you find better options set-ups and improves your trading.
Type "covered calls" into a search engine and almost everything you find provides the following tenets:
This is a great one from Wikipedia:
This strategy is sometimes marketed as being "safe" or "conservative" and even "hedging risk" as it provides premium income, but its flaws have been well known at least since 1975 when Fischer Black published "Fact and Fantasy in the Use of Options". According to Reilly and Brown,: "to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels."
This type of option is best used when the investor would like to generate income off a long position while the market is moving sideways. It allows an investor/writer to continue a buy-and-hold strategy to make money off a stock which is currently inactive in gains. The investor/writer must correctly guess that the stock won't make any gains within the time frame of the option; this is best done by writing an out-of-the-money option.
This is not to pick on Wikipedia; that passage cites to a number of sources that repeat the same things.
Let's break this down: the quote says three times that you need to guess that the stock price won't change much:
It concludes that this is "best done" with an out of the money option.
Wrong wrong wrong! On many levels.
First, you don't have to guess about price movement to avoid losses. This is only true if you're out of the money, but if you are deep in the money, then you would have a cushion between the strike price and the stock price. And, since you only begin to see losses if the stock price drops below the strike, having a big cushion means you can be wrong about the near-term price action and still be profitable with your covered call. The only thing you now need to avoid is being really, really, wrong, and that's a lot easier to do than guessing about a few bucks of price movement.
Second, on the flip side, it is false that you have to guess that "the stock won't make any gains within the time frame of the option." Why? If the stock goes up, even way up, then you win! You keep all your premium. This isn't a loss, it just means you didn't win as much as you could have if you knew the stock would go up by a lot. If this is considered a loss, then everyone loses every day because no one can do as well as they might have done with hindsight. With deep in the money calls, the goal is simply to collect your premium. If the stock shoots upward, we don't lose; we win!
Third, and relatedly, conventional wisdom says that covered calls are only designed to make money off of stocks that are "inactive in gains." Also false. You can make money (good money) writing covered calls on stocks that are falling.
The reason that conventional wisdom teaches us that we need to guess in order to be profitable is because it is so focused on covered calls that are out of the money. If you are out of the money, then it's true: you have to guess and you better guess right. If the stock goes against you by more than the premium you got from selling the call, which is usually just a few bucks, then you start to see losses. And if the stock or the market suddenly corrects you can see a big loss indeed.
When we read about this, we asked why and found no answers.
We found that, contrary to conventional wisdom, there is no need to guess when it comes to covered calls. In fact, we call ourselves "No Guess" Trading precisely because we don't guess about where the price will go -- we don't have to.
The conventional wisdom was only conventional and not all that wise.
It occurred to us one night: what if we put the strike price of a covered call way down in the money. Like 30% in the money. The stock would have to fall at least 30% before we would lose. That sounded like a pretty good idea, and we jumped right in and began trading.
From our knowledgeable friends, we got two criticisms initially. First, we were told that the premiums were just too low if you're that deep in the money. Indeed, they are low. Often, we found less than 1% premium for weekly options, and who wants to mess around for less than 1%? But then we realized there are 52 weeks in a year. Making 0.5% every week is 24% annual returns. Well, Clay Davis from The Wire might have something to say about that, but we can't repeat it here. Suffice to say, that's pretty darn good.
We love how being deep in the money means we don't have to guess! And no guessing means no worrying. Check this out: on January 12, we entered MARA covered calls at a strike of $14 for a net debit of $13.05. MARA was trading in the mid-20s, at least $10 above the strike price. After we entered the covered call, MARA tanked. It went all the way from $26 to $17.50 before rebounding a little. As time went on, however, the call premium continued to decay, and we exited on February 2 for a net credit of $13.55. That's a gain of 3.8% in 21 days, which is more than 66% annualized return. Not too shabby.
Note how MARA's tank into the high teens didn't cause us to lose anything. The volatile price action was so far from our strike, it didn't really budge the anxiety meter. Even when it was at $17.50, it still had to fall another 25% down to $14 before we even began to face a loss.
So, that was awesome and Wikipedia was wrong. Deep in the money covered calls is how we are going to do our investing.
How did we know we were getting enough premium to make our trade worthwhile? What is the chances of losing outweigh the potential gains?
How do you figure that out? Use math.
We relied on gambling principles, most notably "Expected Value," to provide a mathematical framework for thinking about options prices.
When considering whether to make a bet -- which is what options trading is -- we can start at first principles. For example, someone offers to flip a coin with you. They'll pay you $1 if it's heads and you pay $2 if it's tails. Do you play? Good grief, no. You would never play that game. Why? Because your "Expected Value" is negative. Expected Value in gambling means "how much would I win on average if I played, like, a gazillion times." If you played this coin flip game a gazillion times, your average return, or Expected Value, is easy to calculate. It's simply the chance of winning times your win, minus the chance of losing times the loss.
50% * $1 - 50% * $2 = -$0.50
So, if you played this game 10,000 times, odds are you would lose about $5,000.
This principle can be expanded beyond coins. Say you have a six-sided die. You win $6 if it lands on 1 and you lose $1 if it lands on 2, 3, 4, 5, or 6. Do you play? The Expected Value tells you if it's a good game for you:
1/6 * $6 - 5/6 * $1 = $0.1666....
Your Expected Value is positive, so you play this game all day long. If you play this game 10,000 times, you can expect to win about $1,600. Give or take.
The Expected Value can be done for more complex situations. What happens when you have a 20-sided die and you're offered this game: you win $7 for a 13 or an 11, $1 for any even number, and you lose $5 for all the rest. It's getting messy, right, but you know if you sat down you could figure this out. The answer is: you play. The Expected Value is $0.40. On average you win $0.40 per game.
We can do the exact same thing with options prices. You need a probability model that says "here is the chance the option price hits $X by expiration." So, we can calculate the Expected Value by just adding up all the prices times their probabilities, just like we did with the dice and the coins.
"But guys," you say. "There's an infinite number of prices and probabilities."
Behold calculus. Using that incredible tool, we have derived a formula for how much premium "P" you need to get in order to justify the covered call:
This formula is one of our foundational trading tools, and you can use it yourself in Excel. All you need to do is figure out:
U = an estimate of where the price will be in a month. This doesn't need to be too precise. To do this, take the recent 3-month price performance, and divide by 3. Then multiply that by the current price and you have an estimate of next month's price.
S = the one-month standard deviation of prices.
If you have U in A1, S in A2, and the strike price in A3 in your Excel spreadsheet, then the formula is:
=A2/sqrt(6.28)*exp(-1/2*power((A3-A1)/A2,2)) - (A3 - A1)/2*(1-ERF((A3-A1)/sqrt(2*A2*A2)))
Cut and paste that into your spreadsheet and start trading. The result of this formula is the minimum premium you should receive for any given strike if your option expires in one month.
We had a recent commenter note that they were "having a hard time seeing how this would make money." We don't blame them, because that's what everybody says about deep in-the-money covered calls. But we can use math to find good trades, while remaining cushioned from short term price swings.
Using our minimum premium equation above, we have been successful in 2021 with 17 winning covered call trades and no losses (so far). Our covered calls are shown below:
|Entry||Ticker||Strike||Net Debit||Expiry||Net Credit||Exit||Gain/Loss||Duration (days)|
Some overall stats:
The annualized gains on these are outstanding, and the cushion from price action they provide helps us sleep at night.
Math, that great predictor of the cosmos, can help us trade options as well.
We have shown that trading deep in-the-money covered calls using our unique approach is superior to conventional out-of-the-money covered calls. Being deep in the money means you don't have to guess about price movement and you can make money even if the stock falls. And we presented a formula to help you determine if you're getting enough premium from candidate trades before you place your order.
We hope this helps you make better trades and sleep easier at night.
This article was written by
Disclosure: I am/we are long THE STOCKS LISTED IN THE ARTICLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.