Introduction:
Welcome to our second article in the Option Education series. Last time, we wrote about intrinsic and extrinsic value of options. This article will give an introduction to the covered call strategy and explains how you can generate cash flow through options, while holding the underlying stock.
Why you shouldn’t write calls on shares you own
We often read articles about why we should write calls on shares that we own, often the focus is on that "extra return". Other articles go more in depth on the technical details of the “covered call strategy”. In this article I want to look at the question from the other side, why don't we write calls on shares owned?
But let's take a different approach, for starters. Most people who don't invest think that investing is buying stocks, and then selling them later at a higher price. You can forgive those people for their misunderstanding, they are completely inexperienced with investing, they are based on assumptions and prejudices.
On the other hand, you got people who are actively trading or investing who think in the same way. Furthermore, there are people who believe options are only used for extra leverage. This couldn’t be further from the truth.
Options as an alternative to stocks
Initially we think of buying a call option as an alternative to buying shares directly. A second possibility is to write a put option, as an alternative to the direct purchase of shares. The share purchase may then still be weighed against the background of a fundamental or technical analysis. They use the same strategy, but use different products (in this case options instead of shares).
Combining stocks and options (covered call, married put, collar)
You can combine stocks with options as follows (the three most well-known strategies). We can use a “covered call strategy”, where we will write a call on the shares we already own. By writing that call, we enter into a delivery obligation. If our counterparty (who bought the call option) executes its call option (by drawing lots), then “we” (someone will) have to deliver the 100 shares.
A second strategy is to buy a put option to protect the shares, the so-called “married put strategy”. The name of the strategy already betrays the power of combination (stocks + options).
And as a third strategy, a combination of the two previous ones: we can both write a call on the shares (to generate extra return) and buy a put (to protect the shares). The so-called “collar strategy”.
Covered call strategy, why not?
I repeat this again, we write a call, to generate extra return! But, is this always the case? An argument I've heard many times about why investors don't write (calls on their shares) is: "Yes, but what if the stock rises higher (than the output price of my call option(s)), then I'm still missing a profit?". Answer: “Yes, that's right”. But we are going to analyze this in more detail, which is the goal of this article.
Some stocks, where a strong price movement is expected, it can be uninteresting or even unwise to write calls on the shares. Now grab a takeover candidate: If the stock is trading at 20 and there could be a takeover at 30 (a solid premium, but it's just an example), it seems unwise to start writing calls with an output price lower than 30. On the other hand, if the takeover does not go through and the share falls sharply, the investor might have been better off by writing calls or even by buying puts.
A solution that is often suggested is, do not write calls on all your shares owned (too low ceiling). It is recommended to write only at ⅔ (or less) of the position. Problem: to do this, you must of course already have the "luxury" of several packages of 100 shares. Another suggestion can be, write the calls on different strike prices. Example, we own 300 shares of stock XYZ and XYZ is currently worth $50 per share. we would then write 3 covered calls. One with strike price $55, second at $60 and the third at $65.
And if the stock has fallen (significantly or not), and it appears to be bottoming out (and then moving higher), then this also doesn't seem like the ideal timing to start writing calls on the stocks you own.
Suggestion: Don't own 100 shares? Then you can also cover with a “bear call spread strategy” on top of the shares. An extra ingredient also for larger portfolios to hedge the delta longs with a strategy that gives a nice probability of success. Diagonal call spreads, bear oriented, can also offer a nice hedge, which helps lower the gamma effect.
Fear of missing extra return
My experience has taught me that people often don't write calls because they are afraid that otherwise they will miss a certain capital gain on the shares. In short: If you write a $15 call on shares that are currently worth $10, and 3 months later the share is worth $20. Then you lose $5 on the call option, and you win $5 on the shares, but that cancels each other out. Your profit is limited to that 15. From 10 to 15 is an increase of 50% (you can say a nice return for only 3 months). But an increase from 10 to 20 is a 100% return. The reason behind it is often, wanting more and not being satisfied with less. Wanting 100% instead of being satisfied with 50% (I know this is short sighted, because I'm not adding the option premium right now, but this is pretty much the mind-set).
Furthermore, there are investors who do not write (calls) because they are afraid to achieve less return. This may be subjective and my own opinion, but personally I find that too “greedy”, they aren’t satisfied with a certain, very nice profit, but always want more. The rule of experience therefore says that those who want more often end up with less.
To conclude, the main reasons or motives why investors do not write calls can ultimately be traced back to: Fear of missing out on profit, fear of the unknown and/or ignorance (or a portfolio that is too large, then it becomes a luxury problem).
Closing words
I really hope you enjoyed this article and now have a deeper understanding about the covered call strategy. We plan on doing more articles like these where we discuss certain option strategies. Let us know which strategy or option concept you want us to talk about next.
Feel free to send us a mail or contact us through twitter if u have any questions.
If u liked this article, u might want to check out our other articles as well. Our article on Intrinsic and extrinsic value can be found by clicking below.
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