Friday, October 23, 2009

Why I Hate Covered Calls

During the Friday Free Broadcast this morning I showed the attendees one of my account statements. One of the gentlemen in attendance saw a couple of steep losses and suggested that I write some covered calls to "get my money back on those stocks." At first glance, maybe it seems that collecting premiums $2 or $3 per-share at a time might help me recoup some losses on the stock. But the closer you look at covered calls, the less you find to like. In one sense, it isn't even possible to do what he suggests. Why not? If you bought the stock for $50 a share, and it's now worth $20 a share, there will be no strike prices at 50 or above even offered by the options exchange . . . or, if they are available you would get so little premium income writing these frightfully deep-out-of-the-money calls that it wouldn't be worth doing. If the stock is at $20, nobody wants to bet you it's going above $50 any time soon. To collect any decent premium on a $20 stock, the strike price has to be near $20. So, let's see if we have this right--we pay $50 a share for the stock. Now in order to collect $2 or $3 per share in call premiums, we have to be willing to sell the stock for $20 or $25? This is how I get my money back?
Not a chance. The only way to make money on a covered call is to have the stock price remain near your purchase price--and, gee, isn't that sort of what all stock investors would like? If you buy the stock at $50 and sell a Nov 55 call @2, you're okay as long as the stock stays at $48 or higher, but never goes above $55. If the stock drops below $48, you lose just like any other owner of that stock. But--and here is why I absolutely hate covered calls--unlike any other owner of that stock, should the stock go way up, you make none of the upside above $55. None of it. So, you're still exposed to the downside by nearly as much as any other owner--it's just the premium that separates you--but you also sold away your upside for $2 a share, capping it at $7 per share, no matter how high the stock goes.
Of course, it's not likely that a stock will drop to zero that fast, but if the $50 stock drops $10, $20, maybe $30 per share, your days of writing covered calls on it are over. As I mentioned, the strike prices can't be $20 or $30 below your purchase price if you want to make a profit. Right? Could you place a sell-stop below the purchase price? Not really--if that stock is sold automatically, the call you wrote is suddenly naked.
Anyway, next time you hear somebody on the radio or the Internet trying to convince you that covered calls = investment nirvana, factor in some of what I just wrote. And, if you can follow what I just wrote, that's a good sign that you can understand even the toughest options questions.

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