One of the huge advantages to trading options is the ability to trade in any type of market environment. Whether the market is moving higher, lower or sideways, there are option strategies that can make profits.
However, sometimes the sheer number of strategy choices can be a detriment. Nonetheless, it doesn't mean we should just stick to one strategy, as this will take us out of the market during some of the best times to be in. One strategy that tends to get more attention than any other -- though it is often used incorrectly, adding to the risk of the trade -- is a covered call.
Before we talk about the pros and cons of a covered call, let's first define what it is. A covered call is the selling of a call against an underlying security. For example, we might buy
stock at $20, and then sell a 20 call against the stock. This strategy has been popular among so-called options gurus because of its simplicity. It's also considered to be safe, making it a strategy of choice for IRAs.
But there are better strategies to use than a covered call. Nonetheless, there's a place for this strategy, which we'll also discuss.
An options contract gives us control of 100 shares of the underlying security. Thus, if we want to stay covered and not add to our risk, we would need to sell one call for every 100 shares owned.
If we sell a contract without owning the underlying security, then we're considered naked and have unlimited risk. For example, if we buy 1,000 shares of Microsoft stock, we could sell up to 10 calls and still be covered. The idea behind a covered call is that we can pay down the cost of the long purchase by selling calls and bringing in the premium.
Covered Call Strategies
Thus, there are two ways to enter a covered call strategy. One is to buy the shares and sell the calls simultaneously. The other is to sell calls against a long-term holding you already have. The latter is the one time that entering covered calls might be appropriate. To understand why a covered call can be riskier than often discussed, we need to take a look at a risk graph.
One of the best ways to understand the rewards and risks of a trade is to plot a risk graph. Below is the basic risk graph associated with a covered call strategy.
This is just the opposite of what we want to see from a risk graph. We'd prefer to enter a trade that has limited risk and unlimited reward. It's not just the fact that this trade has unlimited risk, but that this risk is of high dollar amounts as well.
For example, if you buy 100 shares of stock that costs $25 a share, you would have $2,500 at risk. However, if you buy an option to control these 100 shares, your cost (risk) would be around $400. I don't know about you, but I'd rather have control of 100 shares of stock for $400 than be at risk of losing up to $2,000. Even if margin is used, you'd have to put out $1,000 and if the stock were to drop, more money would be needed to cover the drop in price.
When is it alright to use a covered call? For traders who have long-term holdings, selling calls to bring in premium might be a reasonable choice. However, if you sell calls against long-term holdings, you're taking the chance of having to sell the stock if it reaches a certain price. Nonetheless, this can be a good way to bring in income if you expect the stock to move slightly down in price or if you expect it to trade sideways.
Of course, if you expect a sharp decline, you would be better served to buy puts, use a collar or sell the stock. One thing that's discouraging when selling covered calls against long-term holdings is when the stock rises sharply. In this case, a stock you've been waiting to rise finally does, but you don't make profits on the gains because you have short calls that need to be covered.
Of course, you could buy the calls back, but the net effect is still a loss of the profits. But if you're willing to sell your stock at a certain price overhead and were planning to hold it even if it declined, then selling calls against these holdings could be beneficial.
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.
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.
By Jody Osborne, senior writer and options strategist at