Covered Calls
Aug. 11th, 2005 01:38 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
peterbirksPB9617 mentioned in his blog that he had been selling covered calls (in Oracle, as it happens) for ages, and that not one of them had ever been exercised. "It's been free money", he said. Then he read about the topic of options in someone else's blog (Jonathan Kaplan's) and mused, probably correctly, that now that he understands the bloody things a bit better, he will probably start losing.
Whenever you enter any kind of financial trade, particularly one involving derivatives, the thing to ask yourself is, "what am I buying or selling here?"
When selling a covered call, the obvious (but wrong) answer is "it's a no lose deal! If the price of Oracle goes up, the option is exercised, but I own the shares, so I sell the shares at a profit to pay for the call option. If the share price doesn't go up, the option expires and I pocket the money!" Indeed, I saw an article in the Sunday Times a few years ago claiming that, by using this method, you could get 20% a year return on your shares.
Clearly, if something looks like easy money, there is a flaw in the argument. So what is that flaw?
What you have to look at here is a whole series of options in a stock. Let's price it at 100p, with the 120% option costing 10% of the stock price at opening. Let's now take a series of prices at the time the option expires.
100
109
95
100
105
95
80
90
100
105
Kerching! 10 covered calls sold, 10p per share profit every time. Easy money!
Now, what about this one.
100
90
80
70
60
50
40
40
40
40
This time, not so kerching. Your options have still never been exercised, so you have made 61p total per share. But you have lost 60p in the share's value. Oh well, you say, but that means I am still 1p better off than I would have been if I had just owned the shares and not written the options! So it's still a good deal.
What about this sequence?
100
130
180
210
260
300
400
700
800
1100
Hmm, now it doesn't look so rosy. The options have been exercised virtually every time, so you had to sell the shares. But if you want to carry on with the trade, you have to buy them back again. "Oh well", you say, "I'm still covered. I haven't lost any money. The rising share price has seen to that." But, of course, you HAVE lost money. You've lost the 1000% return on your money that you would have made if you had not written any call options at all. "Ahh", you say, "but money never seen is money never missed!" OK, have it your way.
Let's try this one.
100
150
90
160
100
180
80
140
80
100
Whoops. This time it's a bit more complicated. Several times you will have had the calls exercised. You then buy your new shares, and they drop in value, so you make the money on the call option, but lose on the value of the shares. Then someone moves in and buys the options at the sub-100p price, which then zooms up to 160p, so you sell the shares to cover the call, but you have to buy them back again. The share price then drops, and so the miserable sequence continues.
So, when you are writing covered calls, basically you are selling volatility. If stuff stays still, then you make money. If it moves in a uniform direction, then your "hedge" (the actual owning of the shares) covers you against your writing the call. But if the share price gyrates wildly before ending back where it started at the beginning, then you do your bollocks.
In this sense, the assertion that you should not write naked calls is a red herring. Covered calls are a hedge against one kind of volatility (a uniform trend), but not against wild up-and-down swings. If you really want to sell volatility, why bother owning the share at all? Just buy collars.
The reason that selling covered calls gained a following was because it's a bit like backing a long odds-on shot in a race, the rules of which you don't really understand, but you don't care so long as you keep getting paid. On the surface it does indeed look like a "no-lose" play. Only when you delve beneath the surface do you see that your trade is a gamble, just like any other.
Whenever you enter any kind of financial trade, particularly one involving derivatives, the thing to ask yourself is, "what am I buying or selling here?"
When selling a covered call, the obvious (but wrong) answer is "it's a no lose deal! If the price of Oracle goes up, the option is exercised, but I own the shares, so I sell the shares at a profit to pay for the call option. If the share price doesn't go up, the option expires and I pocket the money!" Indeed, I saw an article in the Sunday Times a few years ago claiming that, by using this method, you could get 20% a year return on your shares.
Clearly, if something looks like easy money, there is a flaw in the argument. So what is that flaw?
What you have to look at here is a whole series of options in a stock. Let's price it at 100p, with the 120% option costing 10% of the stock price at opening. Let's now take a series of prices at the time the option expires.
100
109
95
100
105
95
80
90
100
105
Kerching! 10 covered calls sold, 10p per share profit every time. Easy money!
Now, what about this one.
100
90
80
70
60
50
40
40
40
40
This time, not so kerching. Your options have still never been exercised, so you have made 61p total per share. But you have lost 60p in the share's value. Oh well, you say, but that means I am still 1p better off than I would have been if I had just owned the shares and not written the options! So it's still a good deal.
What about this sequence?
100
130
180
210
260
300
400
700
800
1100
Hmm, now it doesn't look so rosy. The options have been exercised virtually every time, so you had to sell the shares. But if you want to carry on with the trade, you have to buy them back again. "Oh well", you say, "I'm still covered. I haven't lost any money. The rising share price has seen to that." But, of course, you HAVE lost money. You've lost the 1000% return on your money that you would have made if you had not written any call options at all. "Ahh", you say, "but money never seen is money never missed!" OK, have it your way.
Let's try this one.
100
150
90
160
100
180
80
140
80
100
Whoops. This time it's a bit more complicated. Several times you will have had the calls exercised. You then buy your new shares, and they drop in value, so you make the money on the call option, but lose on the value of the shares. Then someone moves in and buys the options at the sub-100p price, which then zooms up to 160p, so you sell the shares to cover the call, but you have to buy them back again. The share price then drops, and so the miserable sequence continues.
So, when you are writing covered calls, basically you are selling volatility. If stuff stays still, then you make money. If it moves in a uniform direction, then your "hedge" (the actual owning of the shares) covers you against your writing the call. But if the share price gyrates wildly before ending back where it started at the beginning, then you do your bollocks.
In this sense, the assertion that you should not write naked calls is a red herring. Covered calls are a hedge against one kind of volatility (a uniform trend), but not against wild up-and-down swings. If you really want to sell volatility, why bother owning the share at all? Just buy collars.
The reason that selling covered calls gained a following was because it's a bit like backing a long odds-on shot in a race, the rules of which you don't really understand, but you don't care so long as you keep getting paid. On the surface it does indeed look like a "no-lose" play. Only when you delve beneath the surface do you see that your trade is a gamble, just like any other.
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no subject
Date: 2005-08-11 03:35 pm (UTC)Just to clear that up.
And of course the call is a gamble, but when you find an issue like Oracle, one that has a tight trading range and moves extremely predictably on specific market and government news, the gamble is easy to read.
no subject
Date: 2005-08-18 07:40 pm (UTC)...And of course the call is a gamble, but when you find an issue like Oracle, one that has a tight trading range and moves extremely predictably on specific market and government news, the gamble is easy to read.
I think the gamble may seem easier to read, but the risk element gets underweighted, cause that is the really hard part to factor correctly.
In ORCL, the stock has fluctuated between 11.5 and 14.5 for almost a year now. Selling the wings (the 10puts and the 15Calls) has collected all the premium. Selling the 12.5 straddles over the period has been a great money maker, I am sure. The volatility right now in the Jan06 month is implied about 24, with some put skew. That seems like a pretty low number to me for a 13 dollar stock, but it makes sense the number should be low after a year of little movement. The 10Put is .05 bid, the 15Call is .20 bid. Let us say you could sell the strangle at .30, to be nice. If you sell a 10 lot, you are trying to make $300 before commissions. Yep, you quite probably will make that $300.
What happens the times you lose money on the trade, however?
In order to get out of this 10 to 15 range, something significant is going to have to happen (and not be countered by a different significant force). The Nasdaq could make a big run up. Or ORCL could announce a huge military contract (or conversely, the loss of a huge contract). Earnings could grow dramatically cause of increased demand or fall precipitously when competition heats up. And who knows what else. Anything could happen. When it does (and eventually, it will), the seller of $300 of premium is going to own (or be short) 1000 shares of a stock that is exploding away from a long-established range. Everyone is used to that range, when the stock finally moves away with force it probably will catch the premium seller when he is too complacent.
And then there will be a big loss, in the thousands probably, jump risk being what it is.
There are times when selling premium as an individual investor makes sense, but usually they are when you know exactly what you want to do and there is no real hidden risk. If you want to sell premium just to sell it, be really sure you know the level of risk you take. Be ready for worst case scenarios.
And don't be complacent.
no subject
Date: 2005-08-18 09:43 pm (UTC)I've been selling everything covered since I started. I read a few books that focused on selling the premium and away I went. I picked Oracle up in 2002 for a sub 9 price and the following year started selling the calls on it. I basically went very conservative with it as I learned what I was doing. If it were to shoot up and catch me, I wouldn't mind losing the shares for the premium at this point because I've made a decent, if small return on them. I'm much too risk-averse to play the options game naked.