Baseball has a saying, "The ball will certainly find you." Meaning that the one time you are playing out of position, playing hurt or not at full concentration, inevitably the ball will be hit to you – at the most crucial moment – causing embarrassment for you and misery for your teammates.
This old saying can be equally – almost symphonically – applied to options trading. Be certain that volatility will inevitably strike when you are not ready, over extended, or not thinking clearly in terms of risk and objectives. Be ready at all times as that “rare event” – both good and bad could occur when you are least prepared.
Definition of the Covered Call Strategy
In its most basic form, an investor who owns (long) stock sells a near at-the-money call or slightly out-of-the-money call. The seller of this call receives premium (extrinsic value) in return for assuming the guarantee of stock delivery if the stock winds up above the sold (short) call strike. This strategy is called “covered” as the investor owns the stock and will automatically deliver such if assigned by the owner of the call option. A pure “covered call” sells one option for each 100 shares of stock owned.
Popularity of the Covered Call Strategy
Investors and professionals alike have long engaged in the “covered write” strategy by selling call options against their stock portfolio, thereby increasing the prospect of short-term profit in exchange for a capping of any meaningful upside potential. For a mutual fund manager, engaging “covered writing” against his stock portfolio increases the probability of beating his benchmark in the short run however giving up or selling the right to any large upside gains.
The covered call strategy is widely heralded as a “safe investment” from the perspective of a brokerage house, the financial system, and the investor who is eager to generate additional income. It is indeed “safe” as the investor has a clearly articulated risk-reward basis and, the brokerage house won’t be left holding any bag as they have the shares and will deliver them upon potential assignment. However safe doesn’t always equal studious.
An Example of the Covered Call Strategy
Let’s suppose I’m enthusiastic about the long-term prospects of Archer Daniels Midland (NYSE: ADM) and buy one thousand shares at $44.50. (Disclosure: Shover owns shares of ADM as part of his IRA.) I want to sell a call option that offers a satisfactory amount of premium within my investment time horizon. Holding a long-term bullish conviction on ADM stock, I find a January 2016 $55.00 call option that is trading at $1.50 per share and subsequently sell ten of these call options.
This position is considered covered as I sold ten option contracts against the thousand shares of stock that I own. The ADM stock purchase cost me $44,500 and the $1.50 per share premium received for the January 2016 $55.00 call option sale brings my total cost basis down to $43.00 per share or $43,000 ($44,500 – $1,500 = $43,000).
Possible Expiration Outcome
Break-even point downside: $43.00 per share.
Maximum risk: $43,000
Maximum return: $12,000
Three Possible Expiration Scenarios
- January, 2016 expiration - ADM closes at $55.00! I made $12,000 as ADM appreciated $12.00 (recall new cost basis of $43.00 due to the call sale) and option expires worthless. At an expiration price of $55.00 I will keep the stock. At $55.01 I will have my stock “called away”.
- January, 2016 expiration - ADM closes somewhere below $43.00 - I am completely unprotected and will lose 1:1 with any future misfortunes. I’m naked long stock at a price of $43.00 per share.
- January, 2016 expiration - ADM closes somewhere above $55.00! – Whether the stock expires at $60, $90, or $250, I will have been “stopped out” at $55.00 per share. My 1,000 shares of ADM stock will have been taken away from me at $55.00 per share, allowing someone else to enjoy the profit.
Realities of the Covered Call
- “Everyone’s Doing It” Investors and portfolio managers are natural owners of stock and they typically sell out-of-the money calls for additional income or feel pressure to meet a benchmark. Whatever the case, this natural supply of repetitive call selling can and does reduce the implied volatility of the out-of-the money call price – especially as compared to equidistant out-of-the money put prices. We call this options skew. Bottom line: Due to the intuitive penchant of public call selling, you will rarely – if ever – receive enough options premium to satisfy the risk-reward of giving up your upside potential.
- “Great Way to Sift Wheat from the Chaff” Think about it. You have 10 stocks in your portfolio all of which you sell call options against. After the passage of time, some of the stocks have gone up, some have gone down, and some have not changed. The stocks that went up (the goods ones) got called away. The ones that have gone down are most likely well below the call strike sold. What inevitably remains is a portfolio off poorly performing stocks.
- “Violating one of the Primary Principles of Trading Risk Management” The primary objective of long-term success is to maximize income while using leverage to limit portfolio risk. The covered call violates this premise as you are layering an options strategy that caps upside potential while slightly reducing the downside exposure. Surely, there are circumstances where the covered call makes good sense but, the investor must be fully aware of the risks involved. It’s a comparatively negative skewed trading bet – one that you want to stay away from over the long-term.
- “Risking Dollars to Make Pennies” In trading it’s absolutely paramount to continually cut your losses and let your winners run. This is instinctual to some of the world’s best traders – for the rest of us it’s an acquired trait – one that requires tons of discipline and practice. From personal trading and/or investment experience, I can tell you that some of my very best stock convictions – the home run trades (JPM -early 1990’s, AMZN – late 1990’s) were reduced to mediocrity as I was forced to deliver stock immediately before the stock catapulted to the upper atmosphere.