Writing Covered Calls - what's wrong with this idea

[hlpsg]

I've read a number of books about options, and I still like the idea of covered calls. I'm throwing this idea out for any criticisms and loopholes you may spot. (I do understand covered calls have the same risk profile as naked puts).

The basic idea is this, you select a couple of large cap stocks that you think is in an upward trend or trending sideways, and you write covered calls on them. If they get excercised, good, you take the capital and look for new trades. If it goes down that's also ok, you write calls the next month again lowering your breakeven price further.

Now this is the most interesting part:-
If you can get average 4% a month from writing calls, after 2 years, if the stock price doesn't fall to $0, you basically have gotten back all your initial investment (4% * 24 = 96%). So what you have left is the stock which you now own generating a monthly income for you for the rest of your life. So in effect, even if the stock falls to a very low price, it is still able to generate income for you every month, as long as it doesn't go to $0.

Is there anything wrong with this idea? The only problem I can think of is liquidity, that perhaps no one wants to buy the call options you're selling, plus a big bid/ask spread. Other than that I think this is a sound plan.

Will like to hear your thoughts!

Also any recommendations for good books on more sophisticated strategies revolving around covered calls (eg. writing naked puts to buy shares at a lower price, substituting shares with LEAPs, etc.)

Thanks,
HL

 

[JonnyT]

What happens to the shares that go down?

You win on the Option and lose on the underlying.

I think 4% pcm is way too optimistic given that options are a rip off market.

JonnyT

 

[binsley]

(I do understand covered calls have the same risk profile as naked puts).


HL

if you understand that how can you think this is a sensible plan? You would just be selling premium pure and simple. wheres the 4% come from? depends what the stocks do. if you sell across the board to diversify you're simply saying options are overpriced - which they are (insurance premium) - and thats fine as long as you have the capital to stay in biz when the shock happens.
but you can just as well sell the puts - makes no diff.
incidentally if you'd sold premium for the last year across the board you'd be a very rich man .
(which you may well be anyway!!)

Good Luck

 

[RogerM]

hlpsg - it's not as easy as that I'm afraid. First you'll find it very difficult to write covered calls with a month to expiry that will yield 4% per month, unless you pick VERY volatile biotech stocks, or similar, where you'll get called away as often as not. The danger with any covered call strategy is that the share price falls. If you then just write covered calls aggressively above the new low price, all that will happen is that you will have your shares called away very early in any recovery without getting the full benefit from it.

If you buy stocks purely to sell calls against them, then you are paying 2 commissions (share and option) and you might just as well sell naked puts whilst you leave your money on deposit earning interest to provide margin, and then if you get the shares assigned to you, either sell them or sell calls against them until they get called away.

Implied Volatility is very low at the moment and any strategy based on collecting premium is difficult to get to work consistently - and I'm a "dyed in the wool!" premium taker!

 

[osho67]

My performance is not spectecular. I am selling naked puts on us shares . For 9 months to nov I have made average $2866 per month. I have been assigned some shares and potential loss on these shares is $7215 but will be less as I am writing covered calls on these.

I think one can make more money but the problem is findind more volatile shares where premium is high. I tend to write credit spreads on those shares to limit my losses. I only write near month options and sometimes roll it over to the following month.

I would like to improve much and help will be much appreciated.Thanks

 

[hlpsg]

Hello all,
Thank you very much for taking time to point out potential pitfalls, really appreciate the input.

From reading your inputs and doing some thinking I think there's a flaw in my original line of thinking. My initial thought was this, if I sell covered calls month after month with the share price dropping, my breakeven point is also falling, although it may not fall as fast as the share price. However since I'm buying a large cap stock, eventually it'll fall to a low enough level and start rising again, whereas my breakeven point will keep falling every month. If I write calls long enough my breakeven will reach $0, meaning I've gotten all my initial capital back. However what I did not think of was the price going up again, my call getting excercised and I have to buy new shares at a higher price.

I also did not think of this, the price of options depends on the price of the shares. If the share price drops the premium I can recieve from selling calls (or naked puts) will also drop. This will in effect reduce the overall percentage point I will recieve wrt my initial capital from collecting premiums.

Is this new thinking correct?

Thanks!
HL

 

[animal]

The good thing about covered calls is that the risk is hedged by the stock
The bad thing is that you get hit twice for commissions (and spreads) so the brokers like you

It is a reasonable thing to hold 50% of the stock compared to the options but you need the cash in the a/c to allow for the risk of 100% exercise

You can be very agressive and sell the options naked but you have to put up the margin.
The big risk is a takeover bid appearing so you have to be very picky which stocks you go for

imo covered calls are best for someone who is an "investor" who is very comfortable with long term holdings but savvy enough to know when they are at the top of their range, likely to fall for a month or two but still content to hold. Then sell the options for "an extra divi"

4% per mth IS regularly possible with options ( I do index based trades)
No free lunches though, the market knows how to bite hard.
Decide the size of position you are comfortable with, then halve it.

 

[StockMarketGenie]

Covered calls do work but you must be disciplined.

Apart from a less than amazing return there are only two things that can go wrong with covered calls.

One is that the stock price rises above the strike price and so you miss out on potentail profits from the stock trade [but you still make a profit]. The other is that the stock price drops significantly and you therefore have a paper loss.

To avoid these problems, I use the following rules:
1 only use liquid stocks
2 the stock price should be trending sideways
3 you expect the stock price to remain neutral or move only marginally up
4 maximum of 4 weeks to expiry
5 strike price higher than purchase price
6 have a stop loss on the stock and exit the trade and sell the stock if it is hit.

 

[Rainmaker]

There is a risk to holding shares. The return you get for taking this risk is the upside potential of the underlying share. If you are giving a big chunk of this away, but still retaining the downside risk, you are bound to lose in the long run. Writing covered calls (without doing anything else more sophisticated) is not dissimilar to any other kind of investment, in that you need to understand and balance your upside vs downside. Writing covered calls can fool newbies, as it seems to have a high succes rate (but with small returns). However, once in a while, the market will tank and take away these returns.

 

[bulldozer]

HL, your quote below

"Is there anything wrong with this idea? The only problem I can think of is liquidity, that perhaps no one wants to buy the call options you're selling, plus a big bid/ask spread. Other than that I think this is a sound plan.

Will like to hear your thoughts!"
=======================================================================
HL,
A good way to understand CC would be: Ask yourself what would the value be of the underlying [stock] or the whole of your positions if the stock drops by more than 40%?
And do the same exercise [maths % ] if the stock rise by more than 40% what the value would be ? Once you've done that now deduct all your fees what are you left with? now deduct your interest payments
Its very important to work out all the maths and % b4 entering a trade.

bull

 

[hlpsg]

HL, your quote below

"Is there anything wrong with this idea? The only problem I can think of is liquidity, that perhaps no one wants to buy the call options you're selling, plus a big bid/ask spread. Other than that I think this is a sound plan.

Will like to hear your thoughts!"
=======================================================================
HL,
A good way to understand CC would be: Ask yourself what would the value be of the underlying [stock] or the whole of your positions if the stock drops by more than 40%?
And do the same exercise [maths % ] if the stock rise by more than 40% what the value would be ? Once you've done that now deduct all your fees what are you left with? now deduct your interest payments
Its very important to work out all the maths and % b4 entering a trade.

bull

Hi Bulldozer,
Thanks for that explaination, what you've said makes it much easier to understand.

HL

 

[StockMarketGenie]

If anyone holds a position that drops 40% [or in the case of CC rises 40%] without taking appropriate action they don't know what they are doing.