Writing Covered Calls - Strategies and Traps

Covered call traders and investors make a common mistake when writing covered calls.  Make sure you do not fall into this trap!

COVERED CALL TRADING - DEFINING THE PROCESS

A covered call trade is simply the sale of one call option against 100 shares of stock.  The investor or trader receives a cash premium for selling the call option.  That call option will eventually either expire worthless or it will be exercised and the investor's stock sold at a pre-determined price.

If the call option is exercised, and the stock sold, the maximum return will have been realized on the covered call trade.  The investor will keep the premium from the sale of the call option and will receive cash from the sale of the stock.

Should the call option expire worthless, the investor will keep both the cash premium from selling the call option as well as the stock.  Another call option can then be sold and the process of writing calls repeated.

COVERED CALL POSITION RISKS

The most commonly appreciated risk of a covered call position is a downturn in the stock's price.  A small drop is not worrisome as the investor or trader can continue to sell covered calls against the stock and is protected against a modest price drop by the premium collected from each successive sale.  However, a significant deterioration in share price is a threat that must be planned for.

Another commonly appreciated risk of writing a covered call is the missed opportunity cost.  By selling a call option against their stock, the trader is placing a cap upon the potential returns of an appreciating stock.  Each covered call position carries a maximum return, whereas the uncovered stock can appreciate infinitely. 

Many covered call traders react to increases in the stock price by repurchasing the call options.  This typically results in a loss to the extent a greater sum is paid to repurchase the call option than was received from the sale.  The hope is that the loss incurred on the call option will be offset, indeed exceeded, by continued gains in the stock.  Of course, the danger of this approach is that the stock will not continue to rise.

More importantly, an investor or trader who attempts to buy back an appreciated call option has fallen victim to the discretionary call writing trap.

COVERED CALL WRITING STRATEGY TRAP

Discretionary covered call writing must be distinguished from a systematic call writing strategy.  Systematic covered call writing involves the systematic sale of call options against stock with the single minded purpose of gathering monthly premium.  The only concern paid to the underlying stock share price is the possible early exit of a position that has triggered a stop loss.  The goal is to benefit from the collection of time premium and not from unrestricted capital appreciation.

Discretionary traders will write calls when they think their stock is not likely to move higher.  Their hope is to collect premium from selling call options during periods of market consolidation but to let the stock run higher during market rallies.  No one can predict future market action, however.

What invariably happens is that after the calls are sold, the stock breaks out of its consolidation pattern forcing a repurchase.  Once the calls are bought back, the market may or may not continue to reach new highs.  Eventually, a pause will ensue and the discretionary call writer will again entertain writing another call option.  Because it is extraordinarily difficult to accurately time the market, most discretionary call traders find themselves on the losing end of the equation.

TO WRITE OR NOT TO WRITE, CALL OPTIONS THAT IS

The pitfall of trying to reap the 'best of both worlds' is that we miss out on the best each world has to offer.  If you are going to write calls against your stock, do so in a consistent or systematic manner with a focus upon collecting monthly premium.  The premium from the monthly sale of call options is where you will find your profits.

A growth investor should focus upon maximizing capital appreciation and learn to be patient during market consolidations.  While enhancing returns with occasional premium collection is an attractive idea, you are probably best served by sticking to your core strategies.  If you wish to take advantage of a consolidation, there are alternative approaches to premium collection that may be more appropriate to your overall objectives.

Of course, there are some who can successfully combine strategies.  Even these talented few will develop their methods with precise goals in mind.  Where ever you happen to fall in the broad spectrum of investors and traders, keep your goals and objectives in mind and be wary of the ever present trap that exists for those who substitute short-term profiteering for their long-term strategy.