Beware the Pitfalls of Covered Calls

Risks are often understated and rewards overstated for this useful trading tool.
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With stocks hitting multiyear highs as the year draws to a close, many investors are looking to options to secure profits, hedge positions and boost returns.

Among the most popular 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, hence the alternate term of "buy-write" to describe the strategy. While covered calls are a great tool, one that

I've written about and use in the

OptionAlert

model portfolio, they don't come without drawbacks. Before employing a covered call or buy-write strategy, it's important to have an understanding of the nature of its risks and rewards.

Matthew Shapiro, president of MWSCapital, a Chicago-based investment adviser, likens it to a bond. "A covered call is not a risk reduction strategy," he said. "It is a substitution of the standard risk and reward distribution of owning a stock for the payoff profile of owning a bond." He thinks that investors should focus on income generation rather than risk reduction.

It's Not a Hedge

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. I'd go so far as to make the case 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.

For example, assume one looked to establish a covered call in

IBM

(IBM) - Get Report

on Wednesday. With the stock trading around $83.50, one could sell the $85 call for $1.50 per contract. This offers protection down to $82, or just a 1.7% decline. And even those numbers are misleading, because they represent the value at expiration.

A week ago, when shares of IBM were trading for $90, you could have sold the January $90 call at $2.00. Now, with the stock at $83.50, that call is still worth 45 cents in time value. This means the position is looking at a loss of $5, or 5.5%, a slight improvement over the $6.50, or 7.2%, loss of just being outright long the stock, but not what I would consider a meaningful reduction in risk. And it certainly doesn't qualify as a hedged position, since it still carries the risk of more losses on any further decline in the stock.

"Buy-writes are advertised as a conservative strategy, but one must have an exit strategy when the underlying goes against you. It is a discipline you must have," said Elliot Spar, chief option strategist with Ryan Beck. This means it's probably not a good idea to roll down the position, i.e., sell 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.

Measuring Returns

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 a static stock price to show how selling 30-day options can produce double-digit annualized returns.

This is true in theory, but it's hardly easy to achieve this in reality. There's no guarantee that one month's returns represent a repeatable event. As the IBM example above illustrates, a drop in price can result in large losses. Even though Shapiro of MWSCapital likens the strategy to a bond and typically uses options with at least three months remaining until expiration, he points out that the profit graph or yield of a covered call is not a straight line. Rather, "there is a spike in the return, and the bulk of the payoff comes at expiration." He explains that this spike comes in exchange of forgoing the "wings" of the unlimited profit-and-loss graph associated with owning the stock outright.

Choosing the Approach

One way to help 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.

With our IBM trade, the crossover point would be $86.50 (the $85 strike plus the $1.50 premium collected). If shares trade above this price, the covered position's profits will have achieved their $3 maximum return, but long shares purchased at $83.50 would still profit on any further price increases.

Of course, stock selection, time frames and volatility, both real and implied, will ultimately determine the returns. Shapiro currently has covered call positions in

Symantec

(SYMC) - Get Report

and

Marvell

(MRVL) - Get Report

. He is short the July calls in each and has an expected rate of return of 13%-15% for a six-month holding period.

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 I recommend is

New Insights on Covered Calls

by Lawrence McMillan and Richard Lehman.

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Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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