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"What's Your Single Biggest Question About Options
Trading?"
Question:
"Hi Ron, I heard that
we could write naked covered calls and get our position covered or
limit our loss. May I know how and what are the pros and cons of
doing so? Thank you. "
- Jason (Asked
July 3, 2005 - 9:22 PM)
Answer:
"Hi Jason,
Covered call writing (selling) is one of the
most popular strategies especially for beginners. Part of the reason
is that it involves stock ownership, which is something that all are
familiar with prior to learning options. While there are benefits to
the strategy there are many hidden risks as well so that’s what we
want to cover here.
A covered call is a strategy where the
investor buys shares of stock and then writes (or sells) call
options against those shares. (The person who “writes” the contract
is the one who sells it much like when your insurance company
“writes” a policy for you. They are the writer, or seller, and you
are the buyer.)
Because options generally control 100 shares
of stock, the investor needs to purchase 100 shares of stock for
each call option that is written. If you buy 300 shares of stock you
can write up to 3 call options; if you buy 500 shares you can write
5 calls and so forth.
When you write a call option, you have
the potential obligation to sell shares of stock, which will only
happen if the stock price rises sufficiently. But because you
already own the shares, there is no risk to you if the stock price
rises. You’ve already paid for those shares and know your costs up
front. However, had you not already purchased the shares then you
would be considered a “naked” call writer and may have to purchase
shares in the open market if you are assigned on the position.
Because stock prices have no upward boundary on their price, naked
call writing is one of the most speculative of option strategies.
Covered call writing allows you to sell calls without this upside
risk.
The benefit of writing calls is that the call writer
receives a premium from the call buyer. This premium is immediate
cleared cash and can be used for anything the call seller wishes; he
does not need to wait until expiration to collect the cash as many
believe. The cash also serves as a cushion if the stock price should
fall; in effect, it hedges the downside risk of the stock to some
degree. For instance, if you buy 100 shares of stock for $50 and
write a $50 call for $3, then the stock price could fall by the $3
premium to $47 and you’d just break even. So while covered calls do
limit the potential loss, they only do so to a small degree. Still,
because of this downside protection, covered call writing is
considered to be a safe strategy and one of the reasons it is so
popular. That’s the good side to the strategy.
The downside
to the strategy is that you are still exposed to all downside
movement in the stock’s price beyond the option premium. In the
extreme, if the stock in this example were to fall to zero, you’d be
out $47 rather than $50, which is not much consolation. If you were
already holding these shares in your account or are truly willing to
assume that risk then covered call writing can be viewed as
conservative. However, many traders who are new to options hear
about the “conservative” covered call strategy and then buy shares
based on the option premiums, effectively running the strategy in
reverse. In other words, they let the option premiums dictate which
stocks they should buy. Without even knowing it, they have turned a
conservative strategy into a highly speculative one. This is
obviously one of the downsides to the strategy if you are not aware
of it. It’s an easy mistake to make. To avoid this trap, before
entering a covered call, be sure you are comfortable in holding
those shares; otherwise, you should see it as a speculative
investment.
Another negative to the strategy is that the
investor caps the upside gains in the stock. Using the above
example, the most you could ever make on the strategy is the $3
premium brought in from the sale of the call. If that stock is
trading for $70, you’re not going to feel too good about the trade.
However, most astute investors realize that this is merely a lost
opportunity and not a loss. While this may not be a fun situation,
it should not be regarded as a risk of the strategy."
- Ron
Ianieri
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