Options Forum: Covered Calls 101

Does it make sense to use a covered-call strategy with option volatility so low right now?

-- J.S.

The simple phrasing of this question belies the breadth and depth of its inquiry. A covered-call strategy is one of the easiest option plays from a conceptual and execution standpoint. It's also among the most overused and misapplied strategies.

I will try to serve up my answer in two digestible courses. In part 1 today, we'll sample some good and bad aspects of using covered calls as a hedging or income-generation strategy, particularly on specific individual issues. In part 2, we will dig into using covered calls or buy-write programs as long-term, broad market approaches whose goal is to reduce portfolio volatility and smooth returns.

Probably the biggest misapplications and most disappointing results of a covered-call strategy occur when an investor has held a stock for a long time and has significant gains on it, then decides to write calls as protection or a means of generating income. Selling calls against long stock only offers minimal downside protection. People often end up watching their profits evaporate as a stock moves lower and costs increase because of frequent adjustments or rolling of the option-write.

Sell Stock to Reduce Risk

My advice? If you own a stock with significant gains and want to reduce your risk, consider selling some of your shares instead of writing calls. This is true in any environment, but especially so on stocks with low volatilities. For example, an ExxonMobil(XOM Quote) investor -- with the stock's three-month historical volatility in the low-20% range, it's fair to say it still falls in low-volatility category -- might have considered selling some calls to gain some protection when the stock was hitting new 52-week highs this past week.

On Tuesday, with Exxon Mobil trading at $63.50 per share, let's assume an investor sold the April $65 call for around $1.25 per contract. This provided 1.9% protection, down to $62.25. The stock subsequently declined by more than 4.5% to $60 in the next two days. Now the investor faces the decision of rolling down to maybe selling some calls with a $60 strike, which would only provide another 2% protection and completely eliminate any further upside beyond $62 per share, or standing pat and owning the stock with no downside protection at the current level. Deciding the right course of action requires you to make a number of tough short-term market-based or trading decisions.

Compare this with the simplicity of selling a portion of the stock. Assume you owned 1,000 ExxonMobil shares. Selling 100 shares at $63.50 would not only lock in profits but reduce the position's overall risk by 10% throughout the holding period for every price level. Selling 10 of the $65 calls might have saved you about $600. (Selling 100 shares at $63.50 means the equity of a 1,000-share position dropped by $3,150 when ExxonMobil hit $60; holding 1,000 shares against 10 short calls saw a drawdown of $2,550 on the basis of Thursday's closing prices.) But now it offers a negligible 0.05% of protection or reduced risk, yet still limits gains.