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Reaching for Yield

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When investors start feeling comfortable, they "reach for yield" by making investments that promise higher returns but at a higher level of risk. One of the most basic options strategies - widely touted as "conservative" by uninformed promoters - is a common source of frustration in this kind of environment.

I'm talking about covered calls. Investors who own substantial stock positions will sometimes try to squeeze some extra returns out of their holdings by selling call options against their shares. If the stock trades at expiration below the strike of the calls, the investor pockets both the premium received from the options and any gains made in the underlying.

One reason that covered calls can be a bad idea for casual investors is that they entail giving up a lot of upside price potential in the stock in exchange for a relatively small premium. This unfavorable payout is not a mistake in the options market; rather, it is an effect of the investor tendency to sell options and buy shares at the wrong times. When implied volatility is generally low, like it is right now, very bullish investors would be better off swapping stock shares with purchased call options. A stock replacement strategy is preferable to a covered call approach here because the former will let investors lock in equity gains without giving up further upside potential.

Additionally, the implied volatility skew in equity options mitigates against call selling. Out of the money put options tend to be priced at much higher levels of volatility than out of the money calls, which means covered call sellers (who also tend to be hedging put buyers) are usually getting the worst possible deal - selling the cheapest part of the options curve when times are good and buying already-expensive puts when the market stumbles.

Instead of selling calls against your stocks, if you have a neutral or modest directional bias, consider selling out of the money put options instead. You will pocket a better premium due to the volatility skew, and even though selling puts "naked" might sound alarming, the payoff diagram is identical to that of a covered call position. This is also a good test of your broker; a competent firm that will let you trade covered calls will not treat cash-secured naked puts as problematic.

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