Problems With Covered Call Writing
May 2005
What Is Covered Call Writing?
Covered Call writing is where an investor owns a stock and sells call options short to try and pick up a further yield. For example;
- Buy 1,000 shares of Standard Chartered at £9.09, and
- Sell short 1 Dec £10.00 call receiving a credit of £0.125 per 1,000 shares (£125)
- If the shares rise above £10.00 they will be called off you at that price
- But it's not all bad news because your profit will be £0.91 (share price rise) + £0.125 (option sale) = £1.035 or 13.86% in less than 6 months
- If the shares do not rise above £10.00 then you'll keep ownership alongside the £0.125 per share that was received for the selling the call option
- The best result is therefore for the shares to settle at exactly £10 on the December options expiry date because then you keep both the shares and the options premium
But is it really worth selling the right to sell shares at £10.00 and only receiving a paltry £0.125, which equates to an extra 1.37% of the original share purchase price? Most probably not. The cheapness of the options is due to the very low option volatility. A year or two back (2000-2002) these same call options may have been worth triple or even quadruple the present day prices so selling calls against stock then was far more lucrative.
This is why investors shouldn't box themselves into a corner following the same strategies in all types of markets. If you talk to an options broker he'll report that many of his clients who in the past have been active covered call investors have now backed off because it's just not worth selling options that are this cheap.
A covered call trader is by nature bullish because he first has to buy the stock and call options should only be sold as an afterthought. So if the prices for options aren't attractive then wait patiently, which in the case of this present market may well be many months if not into 2006.
The Twist in Covered Call Strategies
Many people believe the false statement that trading covered calls is low-risk whereas selling naked puts is extremely high-risk and downright dangerous. But the two strategies are almost identical in both potential profits and losses.
This is why options can be so tricky to understand because one strategy can be mimicked by doing subtle opposing trades. In order to prove this point look at the following.
- Trader A buys 1000 Barclays at £4.67
- Sell 1 Oct £5.00 call at £0.073
- If Barclays went broke the trader would lose £4,670 on the shares but gain £73 on the worthless options
- Net result - a loss of £4567
- If the shares go to £20 then the profit on the shares will be £0.33 + the option premium of £0.073 or £403
- Trader B own zero shares in Barclays
- Sells short 1 Oct £5.00 put and receives £0.44 or £440 (each option is on 1,000 shares)
- If the company goes broke the options will be worth £5.00 for a net loss of £4,560
- If the shares go to £20 then net profit will be £440 as the options expire worthless
So give or take a few Pounds the P&L profile from a Covered Call strategy and selling naked puts is almost the same. People who therefore use Covered Calls but shun selling naked puts because they're too risky are getting confused.
Selling puts naked is also slightly cheaper because there is no commission to pay on buying the stock or Stamp Duty. Having said that most traders who use Covered Call type strategies don't sell short naked puts because they are owners of stock anyway, therefore selling calls makes far more sense.
See Also
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