Sunday, November 1, 2009

Covered calls

"It is widely known that options traders, especially option buyers, are not the most successful traders. On balance, option buyers lose about 90% of the time." - Kerry from Spike trade

The key here is to sell options and almost never to buy options. One of the few exceptions that I can think of is a protective put to protect your long portfolio as a retail investor in a severe bear market or an index put if you are a fund manager trying to protect your client's portfolio (which is usually long in nature).

Why is that so?

The simple answer lies in the fact that time works against you when you buy an option. The premium that you pay for the rights you receive in an option has time factor in it and this component decays exponentially in the last 90 days before its expiry (which is usually the third Friday of the month).

There are two ultra-conservative strategies around selling options that many retail investors can use to their advantage -- covered calls and short put. We will only discuss about covered calls in this post.

What is "covered calls" and when do you use it?

"You own a stock that is part of your long-term investment portfolio. You like it long term, but don’t see it going anywhere over the short term and would consider selling it, given the right terms. You would also like to generate some income, but you aren’t interested in selling your stock only to buy a CD with a next-to-nothing return.

Given these conditions, many self-directed (or “retail”) traders use covered calls to generate income in their accounts. It is highly conservative and therefore widely popular. In fact, many stock traders begin trading options this way. The strategy can also be used to finance purchasing long stock positions: if used in conjunction, it is known as a “buy-write,” when the investor buys the stock and writes (or sells) the call. A covered call is equivalent to a cash-secured put." - Monster options

There are two basic pre-requisites that you need to be aware of:

  • you have already owned the stock
  • you feel somewhat bullish but not too bullish about the prospect of the stock you purchased
Essentially, what the covered calls do to your position are the following:
  • it limits your upside potential; you will still make a profit if you are assigned which is precisely the reason why I mentioned that you feel "somewhat bullish" about the prospect of the stock in the short term but bullish in the longer term as mentioned above:  (Strike – Entry) + Premium received
  • It helps to lower your breakeven point if you are caught holding a stock which has gone lower than entry price:  Break-even point = Entry price – Premium received
Obviously, you will not be assigned in this case but you get to keep the premium and you are able to sell another covered call the following month. You could generate about 2% to 3% of the capital you invested in that particular stock if the implied volatility is decent. Theoretically, you could get a return of 24% - 36% in 12 months if you are not assigned at all.

Personally, I think this is a tremendous strategy and should be part of anyone’s arsenal when trading the US market. This is not available in the Singapore and Hong Kong market. If you have gone long in those market, you only have the dividends to "lower" your breakeven point if the prices stay stagnant for an extended period of time.

1 comment:

Anonymous said...

CONCEPT: selling option premium & reaping benefits of time decay is the most CONSISTENT way to profit in the options marketplace - JL Lords