Writing covered calls: strategies and pitfalls
Covered call operators and inverters make a common mistake when writing covered calls. Make sure you don’t fall for this trap!
Negotiation of covered calls: process definition
A covered buy transaction is simply the sale of a call option against 100 shares. The investor or trader receives a cash premium for selling the call option. That call option will eventually expire worthless or be exercised and the investor’s shares will be sold at a predetermined price.
If the purchase option is exercised and the shares are sold, the maximum return will have been obtained in the hedged purchase transaction. The investor will keep the premium from the sale of the call option and will receive cash from the sale of the shares.
If the call option expires worthless, the investor will keep both the cash premium for selling the call option and the shares. Then another call option can be sold and the call writing process repeated.
Covered call position risks
The most commonly appreciated risk of a covered buy position is a fall in the share price. A small drop is not a concern as the investor or trader can continue to sell covered calls against the stock and is protected against a small price drop by the premium charged from each successive sale. However, a significant deterioration in the share price is a threat that must be planned for.
Another commonly appreciated risk of writing a covered call is the lost opportunity cost. By selling a call option against his shares, the trader places a limit on the potential returns of an appreciating stock. Each covered call position carries a maximum return, while the uncovered stocks can be appreciated infinitely.
Many covered call operators react to increases in the share price by repurchasing call options. Typically, this results in a loss to the extent that a larger sum is paid to buy back the call option than was received from the sale. The hope is that the loss incurred on the call option will be offset, in fact exceeded, by the continued gains in the stock. Of course, the danger with this approach is that the stock will not continue to rise.
More importantly, an investor or trader trying to buy back a appreciated call option has fallen victim to the discretionary call writing trap.
Deck Call Writing Strategy Trap
Discretionary covered call writing should be distinguished from a systematic call writing strategy. The systematic writing of covered calls involves the systematic sale of call options against stocks for the sole purpose of obtaining the monthly premium. The only concern paid to the underlying share price is the possible early exit from a position that has triggered a stop loss. The objective is to benefit from the collection of the time premium and not from the unlimited appreciation of the capital.
Discretionary traders will write calls when they think their shares are unlikely to rise. His hope is to charge a premium for the sale of call options during market consolidation periods, but to let stocks rise during market rallies. However, no one can predict future market action.
What invariably happens is that after the call options are sold, the stock breaks its consolidation pattern and forces a buyback. Once the options are bought back, the market may or may not continue to hit new highs. Eventually, there will be a hiatus and the discretionary call writer will once again entertain himself by writing another call option. Because it is extraordinarily difficult to time to market accurately, most discretionary call operators are on the losing side of the equation.
To write or not to write, call options that is
The trap of trying to reap the best of both worlds is that we miss out on the best that each world has to offer. If you are calling against your shares, do so consistently or systematically with a focus on collecting the monthly premium. The premium from the monthly sale of call options is where you will find your earnings.
A growing investor should focus on maximizing capital appreciation and learn to be patient during market consolidations. While it is an attractive idea to improve returns with an occasional premium fundraiser, you will probably find it more helpful to stick to your core strategies. If you want to take advantage of a consolidation, there are alternative approaches to collecting premiums that may be more appropriate for your overall goals.
Of course, there are those who can combine strategies successfully. Even these talented few will develop their methods with precise goals in mind. Wherever you are in the broad spectrum of investors and traders, keep your goals and objectives in mind and be wary of the ever-present trap that exists for those who substitute long-term strategy for short-term profit.