DERIVATIVES 'R US/V1N14/Misconceptions About Covered Call Writing
VOLUME 1, NUMBER 14/June 5, 1995
First off, many thanks to Gibbons Burke of Futures magazine for plugging DRU in his recent column in the June issue. I think Gibbons echoed the sentiments of many readers of misc.invest.futures when he complained that getting through all the brokers peddling their wares is like hip-boot wading.
Also, I'm now back after business trips to Raleigh, Salt Lake City and Zurich with a little vacation in Munich and Salzburg. I'd like to say I'm rested and relaxed but about all I can really say is that I'm back. This week's topic is covered call writing.
Covered call writing appears to be one of the most popular strategies for serious option traders. Over the years I have noticed, however, that covered call writing is often presented to novices in a very misleading manner. Thus, I'm going to use this week's column to air my own personal grievance about the way in which so-called experts (meaning oftentimes consultants and more often than not, brokers) describe this strategy.
First off, if there are any novices, let me give a quick description of exactly what covered call writing entails. For simplicity let's assume the stock pays no dividends and the options are European (i. e., they cannot be exercised until the expiration day).
If you own a stock and it goes up, you make money. If it goes down, you lose money. If you sell a call, without owning the stock, and the stock goes up and ends up above the strike, the call is exercised. You have to buy the stock at whatever price it's selling for and deliver to the call buyer for the exercise price. If the call expires with the stock out of the money, you do nothing. In either case, you keep the premium.
If you combine owning the stock with selling the call, you end up either keeping the stock or selling your stock for, at most, the exercise price. On the downside, the loss on the stock is cushioned by the retention of the option premium. On the upside, your stock profit is the exercise price minus what you originally paid for the stock plus the call premium that you get to keep.
My complaint about this strategy, or rather with the way in which it is presented by hucksters, is that it is described as an income-enhancement strategy. You own stocks. Why not sell calls against them and pick up some income? They make it sound like there are dollar bills on the floor waiting to be picked up. Or that your stock is generating some income and you're not smart enough to pick it up.
Ok, go ahead and pick those dollar bills up. But you need to realize what you could be missing. You're giving up all of the capital gains beyond the exercise price. Those gains go to the buyer of the call. This may seem simple but you wouldn't believe how many people are duped by this.
I recently had an investment manager tell me that their organization had taken the advice of a consultant about a year ago and instituted a covered call writing program. The consultant had presented it as an income enhancement strategy. Then they missed out on the bull market. Of course, it is easy for us to chuckle after the fact. Who are we to brag about our market timing ability? But the simple fact was that the consultant had not made it clear what they would be missing if the market went up.
Covered call writing is a risk-reducing strategy. It is designed to do precisely what investors do when they choose stocks that pay high dividends over stocks that have greater growth prospects. Covered call writing converts the prospects for uncertain future capital gains into immediate cash flows that resemble dividends. There may be good reasons for an occasional covered call but a formal program of covered call writing might well be no better than simply buying high dividend stocks instead. Of course, there IS a big difference where the broker is concerned. A systematic program of covered call writing generates commissions, not only from the initial sale of the call but also from the occasional exercise of the call, resulting in the delivery of the stock, and from the rolling over into new calls as the old ones expire. Your broker will be quite happy if you do covered calls and that should immediately make you suspicious. The sad thing is that many retired people owning stocks are being ripped off. The notion that they should be willing to give up capital gains for current income may make sense, but they should not see covered call writing as the only way to achieve that goal.
Another misunderstanding about covered calls arises from the way in which the profit is calculated. Let S be the stock price when the call is written, X be the exercise price, C be the call premium and S* be the stock price when the call expires. If the call expires out of the money, the profit is S* - S + C. If the call expires in the money, the profit is X - S + C (I'm ignoring those transaction costs that keep your broker so happy.) I've found that many people have a hard time seeing why I subtract the stock price at the time the call is written. They use the reasoning that you might well have owned the stock prior to when you wrote the call. If that's the way you think, then you don't see the opportunity cost in holding a stock. When you attached the call to the stock, you made a conscious decision to hold on to the stock. You could have sold it, liberating the S dollars for use elsewhere. Thus, you HAVE to count the S dollars even though you may have bought the stock much earlier.
In summarizing, covered call writing is a RISK REDUCING strategy. And where risk is reduced, expected return is reduced as well. That is the first and foremost principle of finance. If you don't believe it, you have the luckiest broker in the world.
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