Writing Covered Calls
Many traders
use covered writing to enhance the returns from their long stock
portfolios. A covered write is the sale
of a call option “against,†or “covered by†a long position in the
underlying security. When you sell calls
against your stocks, you are giving someone the option of buying your stock from
you any time during the life of the option for a stated price–the strike
price–of the option. In return for
giving up all possible gains above the strike price you receive cash for the
options you sold.
Option sellers are said to be
“writing” options because they, conceptually, originate the contract(s)–not that anybody ever sees actual paper contracts.
In times when stocks move in a
sideways, slightly downward pattern, covered writers benefit greatly from the
additional income generated by the sale of call options.
When someone tells me they don’t trade
options because options are too risky, I usually cite the covered write as an
example of using options to reduce risk. And
it’s true.
In theoretical terms, you have reduced your portfolio’s variance.
And returns are enhanced if stock prices remain the same or fall.
However, your calls do nothing to
protect you against losses as the market falls.
This is the only “knock” on covered writing–that it takes
away your upside and leaves you with the same downside risk as a regular
stockholder.
That’s true in theory, but we have
clients who manage to keep some of their upside potential through careful
management of their positions. How?
By rolling. After a stock
moves up, they re-purchase the short calls (at a loss) and sell new calls at a
higher strike. This allows them to
stay in an uptrending stock so that capital gains from the sale of the stock are
deferred. Note that losses from
re-purchasing the short options can be claimed immediately.
The other smart thing these clients do
is sell when options are expensive. Option
prices fluctuate between periods when they are cheap or dear.
If you focus on selling when options are expensive, it can make a big
difference!
Or, refer to the Most
Overpriced Calls page on this site for currently overpriced calls.
At the time of this writing, Home
Depot’s
(
HD |
Quote |
Chart |
News |
PowerRating) options were expensive. An
analysis shows some excellent potential returns from selling just
out-of-the-money calls.
