April 27, 2004

Debunking Old Covered Call Myths
By John Brasher, CallWriter Publisher

Today we will address some general myths about covered calls that we hear over and over. These are mostly spread by uninformed option traders who have not learned strategies to manage risk and squeeze extra profits from their trades. CallWriter has developed a tool that is specifically designed for the situations discussed below. We know what works.

For those of you unfamiliar with covered calls, they are quite simple. You create a covered call when you buy shares of stock and sell (write) call options (calls) on those shares. The price you receive for writing the call is known as the premium, which generally will be 3% to 5% of the price paid for the stock. You are obligated to sell the shares of stock at the call's exercise (strike) price if the calls are exercised. Writing the call creates income from the stock. The calls are considered "covered" because you already own the stock, and if the calls you sold are exercised, you simply deliver the stock to the buyer (known as being "called out"). Buying stock each month and selling calls on it creates a steady income from the stock, much like collecting a dividend each month.

But there are a lot of myths out there about covered calls, many of which are generated by people who just don't understand the dynamics of option trading. Let's cover some of the more common ones.

This may be the most common misconception of all out there. Surprisingly, there are a lot of people spreading this myth, from Motley Fool on down. Many of them are advocates of buy-and-hold investing - which slaughtered investors at the end of the last bull market. But informed option traders know better.

Like most persistent myths, this one is a half-truth. That is, if you write a covered call and the stock price rises, you will indeed miss out on the price rise if you are inert and do nothing to modify the trade. However, there are several easy and simple techniques to capture the price appreciation. One technique is simply to close the call options (that is, buy them back) and sell the stock. Another and very similar technique is to roll the call up, meaning to buy back the calls you sold and sell higher-strike calls. The roll allows you to capture most of the price rise, sometimes over 90% of it. In fact, we invented the CallWriter Position Management Calculator™ for just these very techniques.

Of course, if you do nothing to manage the trade, you still will receive the return that you originally planned. But we at CallWriter are big believers in actively managing trades to squeeze the maximum profit out of them.

Another dangerous half-truth. The true half of this statement is that there are trades where the underlying stock can fall so rapidly that a loss of money is unavoidable. This usually happens on unexpected news when the stock gaps down on the open. The false half is the notion that there are no strategies to limit the risk on a losing trade.

You can always close the call position and sell the stock. But there is an alternative that frequently is better. Just as a covered call can be rolled up, it also can be rolled down by repurchasing the calls and selling new calls with a lower strike price.

Here's a good example: we once picked a trade in UCI, which was bought for $14.90, and we sold the 15 call for $0.87. Unfortunately, at option expiration the stock dropped well below our breakeven point in the trade, and we feared it would drop even further. (It did.) We could have just taken a loss, but instead we sold the $12.50 call the following month for $1.56, which lowered our cost basis to $12.47. We closed the trade with a $0.14 profit instead of taking a loss.

The other technique that we teach to manage risk is to avoid dangerous stocks in the first place. There are some simple rules to picking covered call trades. There are things to look for and things to look out for, all of which we teach our CallWriter members.

This is another common misconception, which has its roots in the notion that covered call writers do not have any trade management options available to them once the trade is run. Many people believe that covered call writers are helplessly stuck in the trade until option expiration. Not CallWriter members, though!

First of all, you won't always be called out just because the calls you sold are in the money at option expiration. This usually is the case, but not always. You can be called out even if they are only pennies in the money, and the higher the open interest, the more likely you are to be called out. You certainly will be called out if the calls are $0.75 or more in the money.

But if you don't want to be called out, you simply buy back the call on expiration day. If the call is at-the-money (ATM) or out-of-the-money (OTM), the call will cost vastly less to repurchase than the premium you received for selling it. The reason is that all of the call premium was time value, which decays over time and goes to near zero at expiration. Thus you could sell a call for $1.50 and buy it back on expiration day for $0.10 or $0.15, which still would leave you with a fat profit. (This technique will not work with in-the-money calls, however, since they don't lose that much value at expiration.)

An alternative is to roll out in time, meaning to buy back the calls sold and sell calls for the following month. This option makes the most sense where the premium for the following month is sufficiently attractive, and the stock still remains attractive.

Also not true! There are experienced covered call traders who routinely sell ATM or OTM calls with a month or more left until expiration and buy them back right at expiration, when they have lost maximum value. This is particularly true of OTM calls, which frequently can be bought back for $0.05 at expiration.

The average trader does not know how to manage covered call trades.

This comment is not an accusation, just a fact. We know from years of experience that many covered call traders cannot consistently make the calculations required to effectively manage trades. The calculations are not that difficult, but they are a real pain to do with a pencil and paper!

One of the things we teach at CallWriter is trade management, which really is just an aspect of good money management. Trade management is the science of squeezing more money out of trades, or softening a loss on a trade going adversely. And trade management is precisely why we developed the world-famous CallWriter Position Management Calculator™ - which no other website has. We developed it for our own trading use, and there is nothing else in the world like it (nor remotely as useful) for quickly and effectively managing covered call trades.

Don't be the average trader - - manage your trades.

If you have had inconsistent success with covered call trades or have had too many of them go bad on you, the two reasons almost certainly are writing the wrong trades in the first place and then not managing them properly. For picking the right trades, we offer the legendary CallWriter Method of trade analysis. We have been making 3% to 5% monthly for traders and picking four out of five winners for years with this simple method, which we teach to CallWriter Members.

But picking good trades is not enough. To maximize profits you have to actively manage the trades. It sounds complicated and hard, but it isn't. In fact, deciding what to do with a trade after you're already in it takes only seconds, using our amazing calculator. It will take your covered call trading to an entirely new level.

Good luck and good trading!