Covered Calls
by hd123sftail | March 8, 2012 9:39 pm
After reading about covered calls I really am becoming interested in giving it a shot. My problem is identifying stocks to try this on. I don’t have a large account so at best I can only buy 1 or 2 options[1]. When I look at the premiums they barely are large enough to make any money. How do I search for higher premiums till I can build up my account? Any advice is greatly appreciated.
Endnotes:
- options: https://www.stockgumshoe.com/tag/options/
Source URL: https://www.stockgumshoe.com/2012/03/microblog-covered-calls/
This definitely works better as an income investment when volatility is high (volatility as reported by the VIX index is really just a measure of the premiums being paid by options traders, which implies what kind of volatility they expect from the underlying stock market), but there is certainly risk if you reach for the more volatile stocks that give you higher payouts — because you can easily catch a capital loss from a falling share price that more than clobbers your income from selling the call.
I dont’ do covered call selling very often myself, but folks I know among this group tend to use the strategy for stocks they know very well and follow very closely, and many prefer stocks with a solid dividend that helps to backstop the share price (and boost your income) — if you’re trying to start with a very small portfolio it can be tough to diversify enough or sell enough options because the commissions eat into what are (if you play it safer) small repeated transactions.
These more conservative options strategies (cash-backed put selling or covered call selling) are not for the impatient, in my experience, pushing for a higher return by using more volatile picks that you don’t know well or by expending your expiration dates out further can be rewarding when you get that quick payout, but it increases the risk substantially. I’m sure there are many Gumshoe readers out there who use these strategies far more actively, and many folks have reviewed their favorite options newsletters and trading services (http://stockgumshoe.com/category/options-or-futures/), hopefully others will chime in with some ideas for you.
The opportunity cot of covered calls is that one sells the entire upside above the strike price. For example:
I own MITK at 9.30. While it was hovering between 7.5 -8.00 I sold a covered call with strike = 10 maturing 3/17, thinking it could hardly rise much above that.
Well, after announcing earnings two weeks back, MITK’s now trading north of 11.5. I hate when that happens. However, I’m not going to try to roll it over, as I think the stock is over-priced and has to correct. I shall be out above my purchase price but will have left too much of the upside on the table.
As Michael Adler has pointed out you give up any upside beyond the strike price when you sell covered calls. A perverse selection effect takes place where the good stocks get called away and the crap stays in your portfolio. I sometimes cynically think that the one way to make a stock I own go to the moon is to sell near the money covered calls on it. Keep in mind that the trick of buying high dividend stocks and selling covered calls on them doesn’t work as well as you might hope because calls get cheaper (and puts more expensive) the higher the dividend. I would not recommend choosing stocks on the basis of how much money you can make selling covered calls on them, since that makes high volatility, not a sound business, the criterion for buying the stock. It’s best to use covered calls where you would normally use a sell limit order, just as you can sell puts rather than use a buy limit order. Also, keep in mind that buying 100 shares of stock and at the same time selling a covered call at strike x is exactly equivalent to selling a cash secured put at strike x.
Let me ask Bob a question about his last sentence. I agree the equivalence when the put is 100% cash secured. But what happens when the put is sold in a 20% margin account? At this point I get confused.
Selling puts in a margin account simply means that you need less cash in your account, because only about 20% of the cost of buying the stock at the strike price must be kept aside. At that point it’s not equivalent to a buy/write in that the buy/write requires more cash (you need to pay for 100% of the shares, not just 20%, or at least 50% if you are buying shares on margin). (In option theory the buy/write is still equivalent to selling puts on margin, because they imagine a penniless trader who borrows every cent of his trading money at the risk free rate. But I’m talking real world here.) Of course if the puts are exercised you have the same legal requirement to buy 100 shares of stock per put at the strike price. If you don’t have the cash to do that you get a margin call. So while margin is a very useful for an options trader it can be very dangerous if overused.
One thing I don’t like about options selling newsletters is that they blow hot and cold about margin. They love to calculate return on margin — Sell these puts and earn 30% in two months! But then they warn you to have enough cash on hand to actually buy the stock if you are assigned on the puts, implying that you’re not using margin. Those same puts sold in a cash secured fashion earn 6% in two months — not a bad trade, really, but it sounds a lot less impressive.
When in doubt sell put spreads rather than naked puts (or call spreads rather than naked calls). Then the margin requirement is the same as your worst case loss, so at least your account can’t go negative (although it can get mighty close to zero).