Beware the Pitfalls of Covered Calls
Among the most popular of strategies is covered call writing. A covered call consists of taking a short position in a call option against a long position in the underlying stock, on a one-to-one basis. And thus the term of "buy-write" to describe the strategy.
While covered calls are a great tool, they don't come without drawbacks. So before ever employing a covered call or buy-write strategy, it's important to have an understanding of the nature of its risks and rewards.
One of the biggest misperceptions is that covered calls are a way to hedge a position. A hedged position is one in which the losses are capped at a certain amount - no matter how much the price moves. Quite to the contrary, a covered call is not really a risk reduction strategy but rather, it is a substitution of the standard risk and reward distribution of owning a stock for the payoff profile of owning a bond. In fact, the case can be made that a covered call is not even a good way to limit losses, and the risk profile is very similar to that of simply owning the stock outright.
Buy-writes are advertised as a conservative strategy, but one must have an exit strategy when the underlying stock goes against you. It is a discipline that you must have - as opposed to selling lower-priced calls - because all this will do is limit the possibility of recouping losses if the stock were to rebound. A good rule of thumb might be to use the break-even point, the price at which the position would be a scratch at expiration, as a mental stop or exit point for closing the position.
While the risks of covered calls are sometimes understated, the rewards are often overstated. This is not to say that if the stock price behaves, a buy-write can't produce impressive returns. Indeed, when brokers or money managers describe a covered call strategy, they use examples of static price to show how selling 30-day options can produce double-digit annualized returns. While this may be a true theory, it's hardly easy to achieve this in reality. And there's no guarantee that one month's returns represent a repeatable event.
One way to determine which strike price offers the best returns is to calculate not only the break-even point (at what point you would lose money) and the maximum profit point (typically equal to the strike price of the calls sold), but also the crossover point. The crossover point is the price at which owning the stock outright or uncovered would deliver a higher return than the covered position. The crossover price is equal to the strike price plus the premium collected.
This is by no means the whole story on covered calls -- there are plenty of nuances, and there's a veritable decision tree of choices of how best to employ this powerful but simple strategy. In fact, there are whole books devoted to the subject. One that comes highly recommended is, New Insights on Covered Calls by Lawrence McMillan and Richard Lehman.
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While covered calls are a great tool, they don't come without drawbacks. So before ever employing a covered call or buy-write strategy, it's important to have an understanding of the nature of its risks and rewards.
One of the biggest misperceptions is that covered calls are a way to hedge a position. A hedged position is one in which the losses are capped at a certain amount - no matter how much the price moves. Quite to the contrary, a covered call is not really a risk reduction strategy but rather, it is a substitution of the standard risk and reward distribution of owning a stock for the payoff profile of owning a bond. In fact, the case can be made that a covered call is not even a good way to limit losses, and the risk profile is very similar to that of simply owning the stock outright.
Buy-writes are advertised as a conservative strategy, but one must have an exit strategy when the underlying stock goes against you. It is a discipline that you must have - as opposed to selling lower-priced calls - because all this will do is limit the possibility of recouping losses if the stock were to rebound. A good rule of thumb might be to use the break-even point, the price at which the position would be a scratch at expiration, as a mental stop or exit point for closing the position.
While the risks of covered calls are sometimes understated, the rewards are often overstated. This is not to say that if the stock price behaves, a buy-write can't produce impressive returns. Indeed, when brokers or money managers describe a covered call strategy, they use examples of static price to show how selling 30-day options can produce double-digit annualized returns. While this may be a true theory, it's hardly easy to achieve this in reality. And there's no guarantee that one month's returns represent a repeatable event.
One way to determine which strike price offers the best returns is to calculate not only the break-even point (at what point you would lose money) and the maximum profit point (typically equal to the strike price of the calls sold), but also the crossover point. The crossover point is the price at which owning the stock outright or uncovered would deliver a higher return than the covered position. The crossover price is equal to the strike price plus the premium collected.
This is by no means the whole story on covered calls -- there are plenty of nuances, and there's a veritable decision tree of choices of how best to employ this powerful but simple strategy. In fact, there are whole books devoted to the subject. One that comes highly recommended is, New Insights on Covered Calls by Lawrence McMillan and Richard Lehman.
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posted by Bob Moser at
8:50 PM
1 Comments:
The article is simplistically pessemistic. Assumes covered calls hedge long side, which they primarily do not, then proceeds to point this out as if it is a shortfall of covered calls!
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Anonymous, at 8:26 PM
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