Joey Investor is long 1,000 shares of ORCL common stock. It is now June, and Joey feels that the market for ORCL is headed sideways over the next several weeks. Therefore, he should
A. sell 10 ORCL Jul calls
B. buy 10 ORCL Jul puts
C. sell 10 ORCL Jul puts
D. buy 10 ORCL Jul calls
EXPLANATION: Always sell options if the market is supposed to go "sideways" or "remain unchanged." That way, you get the premium now, and then the option expires. Don't sell puts if you own stock--if the stock goes to zero, you lose 100% on the stock, then you have the OBLIGATION TO BUY the stock for the strike price . . . even though it's worthless. Sell covered calls in this situation. Joey owns 1,000 shares, so he can cover 10 call options.
ANSWER: A
Showing posts with label covered calls. Show all posts
Showing posts with label covered calls. Show all posts
Tuesday, December 29, 2009
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.
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.
Saturday, October 3, 2009
Covered Call question
A customer just emailed me with the following concern:
I saw a question like the one below on the software my firm gave me--I think it's an internal product somebody higher up put together. I don't think there's a right answer. Can you help?
Here is the qestion:
An investor purchases 300 shares ABC @50 and writes 3 ABC Aug 55 calls @1.50. His maximum loss is . . .
I chose "unlimited" because of the short call position--what am I missing?
REPSONSE:
If the investor only wrote the three ABC Aug 55 calls, his risk would be unlimited, but this investor already bought the 300 shares he is obligated to sell and deliver for $55 a share. Therefore, he no longer worries about the stock rising; in fact, that would be his maximum gain. If the stock rises, he can make $5 per share plus the premium . . . maximum. His maximum loss is now pointing downward--he owns the stock. If it drops from $50 to zero, all he got to offset that was $1.50 per share. His maximum loss, then, is still $48.50 per share, times 300 shares.
Yikes.
That's why they say that covered calls provide "partial protection." The premium income is a nice way to "increase yield" or "increase overall return" on the stock, but it does very little to protect against a big drop. The best way to protect a long stock position, remember, is to buy a put. Having the right to sell your stock at a set price in case it drops is much better than having to sell your stock at a set price only if it goes up. I'm going to leave you with that thought--enjoy.
I saw a question like the one below on the software my firm gave me--I think it's an internal product somebody higher up put together. I don't think there's a right answer. Can you help?
Here is the qestion:
An investor purchases 300 shares ABC @50 and writes 3 ABC Aug 55 calls @1.50. His maximum loss is . . .
I chose "unlimited" because of the short call position--what am I missing?
REPSONSE:
If the investor only wrote the three ABC Aug 55 calls, his risk would be unlimited, but this investor already bought the 300 shares he is obligated to sell and deliver for $55 a share. Therefore, he no longer worries about the stock rising; in fact, that would be his maximum gain. If the stock rises, he can make $5 per share plus the premium . . . maximum. His maximum loss is now pointing downward--he owns the stock. If it drops from $50 to zero, all he got to offset that was $1.50 per share. His maximum loss, then, is still $48.50 per share, times 300 shares.
Yikes.
That's why they say that covered calls provide "partial protection." The premium income is a nice way to "increase yield" or "increase overall return" on the stock, but it does very little to protect against a big drop. The best way to protect a long stock position, remember, is to buy a put. Having the right to sell your stock at a set price in case it drops is much better than having to sell your stock at a set price only if it goes up. I'm going to leave you with that thought--enjoy.
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