OPTIONS
Concerning Your Options
Consider Covered Calls -- And The Caveats
by Kevin Lund
Are there opportunities lurking in this market for you to take advantage
of covered calls?
Some strategies work only under certain
conditions and, all too often, not for the right reasons. Selling covered
calls is a good example. There were a lot of self-proclaimed bull-market
"geniuses" in the late 1990s who did nothing more than sell covered
calls on technology stocks, pulling in wonderfully ridiculous returns of
20-30% or more per month. Each month brought call sellers (writers) two
sources of income: capital appreciation on the stocks they bought, and
premiums from the calls they sold on those stocks. But within about one
year of the emergence of the bear market in the spring of 2000, it became
alarmingly apparent that covered calls spelled disaster for most and did
little to protect those "geniuses" from the sharp declines in
their stocks as well as their trading accounts.
If this is so, why bring up covered calls now? Whether you think
we're in the midst of a "mini-bull" in a larger bear market or
the beginning of a new long-term bull market, it's a ripe environment for
covered calls. However, there are some new rules to keep in mind.
BUT FIRST, SOME BASICS
Covered calls are nothing more than a way to accelerate your return
on investment by selling (writing) a call on a stock you own, giving the
buyer of that call the right to buy (call away) your stock at an agreed-upon
price (the call's strike price). The safety net for covered call writers
is that they are covered because they already own the underlying shares
that may need to be delivered to the call buyer. If they didn't own them,
and they sold an uncovered (or naked) call, they'd have to go out into
the open market and short those shares at higher prices than the strike
of the call -- sometimes much higher, thereby incurring a loss on the position.
The profit for the covered call writer is the premium received for the
call plus any additional amount the stock rises between the purchase price
and the strike price.
Taking a closer look at the risk curve of a covered call (Figure 1),
it becomes apparent why this strategy lost so many people so much money.
Not only is it not as safe as everyone thought; it actually has the same
risk curve as a naked put, which is another high-risk strategy that wiped
out many trading accounts.
FIGURE 1: RISK CURVE OF A COVERED CALL. By taking a close look,
you can see why people lost money using covered calls.
...Continued in the February issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the February 2004
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2004, Technical Analysis, Inc.
Return to February 2004 Contents
