So What are these Covered Calls?

More and more brokers are allowing their users to be able to use the trading and risk management strategy of selling \”covered calls\” otherwise known as buy write style trading. So what is a covered call? Are they too complex? What are the risks?

Calls are a type of option contract (this article is written for American style options) trading the right to buy the underlying security at a given strike price. It\’s important to know that options contracts tend to trade in sizes of 100 share increments and that options expire on the 3rd Saturday every month (but some securities don\’t \”have\” them every month if they are low volume.)

Option prices are based primarily on the following:

  • Underlying volatility (does the stock move a lot of % every day)
  • Price of the underlying
  • Distance to strike price
  • Time Decay (how long until the expire)

Risks

Covered calls themselves carry an inherent less amount of risk than directly investing in a given security. It is hard to lose money by just selling a covered call (unless the security drops and you don\’t buy back your call and sell the stock quickly.) That being said, it is very likely to reduce the earnings that you might have through a security.

Examples

  • Buy 100 shares of BAC at $4.64, sell a call at a strike price of $5 for $0.30 a share, so your price per share is now $4.34. In the end, BAC goes to $5.64/share and whoever bought your option exercises it. You make $5-$4.34=$0.66/share, but if you would not have sold the call, you would have eventually made $1 a share.

Trading

In 2008 and 2009 we\’ve seen systematic volatility in the stock markets increase drastically — and in an overall negative direction. This provides a huge opportunity for a trade to be established on these calls.

\"Possible

The idea is just a simple idea of buy low and sell high, but with the call option we are selling at the height, and buying it back at the lows.

I\’ve taken the 3 month chart of BAC (it has been extremely volatile over this period) and put some dots at the 20/20 hindsight spots of the trading. You\’ll notice that if you had 100 shares of BAC you would have lost a significant amount of value ($10/share),  but thanks to trading covered calls you could have made back up to $6 (very liberal estimate) of that… Not to mention that you\’ve kept 100 share of BAC (something that you think is a pretty solid long term 5 year investment.) And that $6 is in 3 months, so in a year, you could potentially erase all losses if you trade optimally.

But It\’s Not Easy

So you may be thinking that I just showed you how you would never have to work again in life, but you would be sadly mistaken. First of all, you have to be careful with your brokerage fees: I mentioned that tons of brokers are allowing covered calls; brokers like sharebuilder who charge high commissions. Next we\’re talking about a lot of analysis, 20/20 is one thing to say, but when you add that with the emotion of selling close to strike price for more immediate money, you are very likely to not maximize money. To be able to track the stocks you would need to look at them very often and  have some pretty strong technical skills. Finally, there is the possibility in a high news volume market that huge price changes will overshoot your calls, and if you sell a call below your purchase costs, you would be completely out of luck and out of money.