Understanding a Covered Call

Buying stock only for the purpose of selling covered calls is not a good idea. I know this from personal experience. When I first started trading options, I thought covered calls were the safest strategy to use. Thus, I bought a couple of stocks that were mentioned in a prominent financial magazine as strong stocks.

However, as the months went by, these stocks fell further and further, while I was expecting them to come back in the future. That didn't happen, and two of the stocks I bought went bankrupt. The calls I sold against these stocks provided little help compared to the large sums of money I lost. I found out the hard way that spending thousands to make pennies just doesn't make a lot of sense.

Alternative Strategies

So, now that we know the risks associated with covered calls, let's discuss some alternatives. Options are a proxy to buying the underlying security, a leveraged way of controlling shares of stock without putting out large sums of money. For example, if we like Microsoft, why not buy LEAPS instead of buying the stock outright? LEAPS are long-term options that give us control of the stock up to three years out in time.

For example, we can buy a 27.50 call option that doesn't expire until January 2004 for $3.60. This gives us the same control of the stock, but costs us about 15% of the price of buying the stock outright. Now, if we feel the stock is going to trade sideways during the next few months, we could sell front-month 27.50 calls against the January calls to pay down the cost.

If we use the same strike price for both the long-term and short-term options, this would be called a calendar spread. However, we could also sell lower strike calls and buy higher strikes calls, which would be called a diagonal spread. Either way, we're taking less risk and have to put out far less money.

I love calendar-spread strategies because of their ease of use and large range of profitability. If we expect a stock to stay in a certain range for a longer period of time, we can sell calls against the long option for months, eventually more than paying for the long option.

When using calendar spreads, there are two different strategies. One is to use the short-term options to pay down the cost of the long-term option, eventually hoping for a run-up in price. The other strategy is to make a profit from a skew in implied volatility, then get out of both options at a given point in time. There are some key things we can do to find calendar-spread candidates, but there isn't room in this article to discuss the finer details of the strategy.

Another strategy to use if you want to hold a long stock, but want to be protected if the market falls, is a collar. Collars consist of the purchase of a put and a higher strike call. What this does is cap the risk to the downside; but it also caps the possible gains to the upside. However, a collar can often be placed for very little cost, but still with some upside potential.