December 29, 2004

Why Shorter Trades are Better
By John Brasher, CallWriter.com Publisher

There are a number of approaches to covered call writing. Mine is to get in and get out. As a general matter, I am strongly of the opinion that the shorter the trade, the better. To be more precise, I prefer the shortest trade duration that is consistent with achieving an acceptable return. Let's explore why.

My six-year-old grandson likes to dip celery stocks in a rich cheesy dip. Don't get me wrong - he won't eat the celery, but he sure likes to lick the dip off it. My philosophy on writing covered calls is remarkably similar. I am not a stock investor and view the stock as no more than a means to getting the return from selling calls. The stock is my celery stick, and ... well never mind, you get the picture.

Never forget that the stock is, after all, where all the risk is in the covered call trade. The stock is the "bitey" end of the trade. The less time you are in the trade, the less opportunity the stock has to bite you. A few hard facts figure into my trading philosophy:

1.	Premium Compression.  This is my term for the fact that the further out in time the call writer goes, the smaller the return gets. That is, the further out in time the call, the less premium you get per month. If for example you can get $1.00 for selling the front month (current expiration month), you won't get $4.00 for selling the same strike call four months out. In fact, you might not even get $2.00 for it. Thus the further out in time you sell, the more the return per month shrinks. Consider the following example on the Apple Computer (AAPL) 65 Calls and LEAPS Call in December 2004, when AAPL was trading at $65:   JAN 65 FEB 65 APR 65 JUL 65 JAN '06 65 Premium 2.70 4.10 6.10 7.80 11.00 Trade Duration* 1 mo. 2 mos. 4 mos. 7 mos. 12 mos. Total Return 4.15% 6.31% 9.38% 12% 16.92% Return per Month 4.15% 3.15% 2.34% 1.7% 1.41%     * Note that the time periods above are rounded to months for illustration purposes. Notice how the return per month drops precipitously after the first four months. The reason is obvious: the market expects volatility in the stock short term, based on pending news or an event. The market is willing to pay more for AAPL options in the short term, but not over the long term. For all stocks, there is a heavy implied volatility skew in favor of the short-term options, because the short term is where the action will be, based on the pending news or event that is driving the premium so high. If your goal is to maximize returns (and it should be the goal), then I fail to see how writing further out in time helps the trader realize it. The stock poses a risk every instant you are in the trade. Money has a time value, and taking a smaller return never adds up. In the above example, selling the JAN 2006 LEAPS call brings in $11.00 in premium, an almost 17% return for a 12-month trade. But getting 4% a month on the same trading capital for those 12 months would bring in a 48% return. Which makes more sense to you?
2.	Long Trades Rob You of Time Decay.  You should be aware that stock options lose the greatest percentage of their time value in the last 30 days before expiration. Time is said to be on the option seller's side, and the reason is that the decay in time value works in the seller's favor. Every day brings the option seller closer to expiration, when the trade ends and his profits are realized. Not only that, but decay in time value (along with collapse in IV) makes it possible many times to close the trade early with an acceptable profit. Time on the other hand is the option buyer's enemy, because every day robs a little of the time value from his long options. One of the greatest benefits of writing covered calls is to collect a fat premium for a call that expires in 30 days or less. When expiration day comes, it usually means that the covered call writer's profit is locked in and the trade is terminated when the writer is called out of the stock. Writing calls further out in time takes away this element of swift time decay from your trading. It picks your pocket. There is no economic advantage for the covered call writer to be in a trade any longer than necessary to capture the return sought.
3.	The Short-Term Horizon is Easier to Forecast.  As I pointed out above, the stock is the sharp end of the covered call trade and where all the risk is. The longer you are in a trade, the longer the stock has in which to bite you. The further out you write, the more you have to pay attention to the intermediate trend of the stock and the overall market. And as s tough as it is to forecast a stock's price over the next few weeks, it is no easier to forecast it over many months! The longer the time horizon, the harder it is to determine direction. While my crystal ball is no better than yours, I feel much more confident about being able to predict the stock's direction over the next 2 - 4 weeks than two to four months. And maybe that is the answer - I do it because I'm more confident in my ability to predict winners over the short term.

All trading is, at the end of the day, about turning your money. Notice I said trading, not investing, which is buying stocks for the long term and holding for price appreciation. By no means do I disparage long-term investing, I just don't do it. It is simply true that all things being equal, the faster you turn your money, the greater the return. Ask any banker! Turn equals return.

Many articles and books on writing covered calls exhort readers to sell calls many months out, sometimes even to sell LEAPS calls. And while I don't knock the practice, premium compression means that the further out in time you write, the smaller the return per month. The above table doesn't lie. That is how premium compression works. The only justification for writing far out in time that I am aware of is to collect a huge premium for the far-out calls and look for a chance to unwind the trade early for a fat return due to time decay or collapse in implied volatility. In other words, even though the trader writes a call, say, seven months out, the trade might can be closed profitably in a month or two. This can be a very smart strategy, and when it works well the trader is turning his or her money instead of staying in longer-term trades. Remember, though, that premium compression works both ways. The calls far out in time never get high enough to offer returns comparable to nearer-term calls, as the above table illustrates. This also means that when the expected news or event occurs and causes the IV and premium in the nearer-term calls to drop, the premium in the calls further out does not drop correspondingly because they were never nearly as high. This makes it tougher to profitably unwind the trade early.

Question:   What is the difference between a covered call and a bull call spread?

Answer:   They are very different strategies. The covered call trade is a conservative position designed to produce a small income while conferring a bit of downside protection against a stock slide. It is a neutral to bullish trade that wins if the stock goes up a lot, goes up a little, holds its price or even goes down a little. That is, the covered call wins in a lot of different scenarios. The covered call is not a spread: it is created by writing call options on stock you already own or buy for that purpose.

Covered call = Buy stock + sell calls

The debit spread (bull call spread) is a bullish trade that creates a debit upon entry. The bull call spread is created by buying a call option on a stock and selling a different call option with a higher strike price on the same stock. The stock has to affirmatively move up in order for the spread to win. It must move ABOVE the trade's breakeven point in order to win, and must close above the higher (short) strike call in order to generate maximum profit. The bull call spread exposes you to a loss if the stock does not move enough and do it on time. You must be a decent market timer to consistently profit from them, since you have to be right about the stock's direction and it has to move on time. However, it caps your profit.

Bull call spread = Buy lower-strike call + sell higher-strike call

The spread caps your return, however. In order to minimize a possible loss, the bull call spread writer sells a higher strike call. Say the stock is at $19 and you create a 20c/25c spread by buying the 20 Call and selling the 25 Call. The 25 call brings in premium (though less than the cost of the 20 Call) and lowers the trade's debit compared to simply buying the 20 Call. However, selling the 25 Call caps your profit. If the stock closes at $26, you would make the $5.00 spread minus the trade's net debit. If you're a good enough market timer to consistently make money from bull call spreads, it may make more sense to buy the calls.

Good luck and good trading!