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Thursday, October 8, 2009

Understading Some Risks Of A Covered Call

By Maclin Vestor

A covered call strategy is great, as it can allow you to get your income back, and put it to work elsewhere quickly. In addition, time value is certain, and covered calls will allow you to collect this value while speculators betting on a stock rising beyond the option price plus what they paid for the option will have to pay this amount to you no matter what. Even if the stock does go beyond this point, you don't incur a loss; instead, you miss out on potential gains. This can cause a covered call strategy to be more stable. You ultimately want the stock to expire at the money as this will allow you to collect the full premium, and still own the stock. Anything above this and your gains of your stock will cover the loss of the call and your gain will ultimately be the same. However, if it goes higher, you will have to repurchase your shares at a higher price, although selling another call against them will result in a higher premium.

Some covered calls will yield a 10% monthly return based on it's time value premium that you collect, meaning that in 10 months you will have your initial investment back if you can successful receive the full time value. The risk is not that the stock goes up in value and that you miss out on potential gains, as the yield will be roughly the same after appreciation, but that the stock goes down dramatically in value. However, you cannot lose more than your initial investment minus the full premium. This is a major point that critics of the covered call strategy often miss, as they say it has "the same risk profile as selling naked puts." This means that if you sell a put you are un-hedged, and if the stock goes to zero, you are also limited to the loss of the strike price minus zero times $100. Where a put owner will gain $100 per share ($10000 per contract) if a $100 stock goes to 0, a put seller will have to pay the put owner this $10,000 per contract. Selling puts is dangerous because people generally do not manage money well. The top 10% of people own the other 90% of wealth generally because the top 10% have learned to manage their money better than the other 90%.Selling puts is dangerous, because if you sell a $100 put for $500 your gain is capped to $500 per contract for a given length of time, and your potential loss is $10,000. Now a covered call owner may be capping his gain to lets say $500, and if the stock goes to zero, he is also going to potentially lose $10,000. So why is a covered call generally less risky? The reason why is that unless the seller of the put has $10,000, then he risks going on margin. In addition to actually having to have put up what the buyer affords to risk, The buyer of the stock not only is required to have that 10,000 before he can buy 100 shares of $100, but even someone with a limited understanding of risk management will do at least something to manage risks, even if it's still investing a high percentage such as 20% of the income that loss is limited to 20% of the portfolio. Technically that buyer should risk only a smaller percentage of his capital. A seller of a put receives $500, but to collect $500 and have to leave $50,000 to the side doesn't seem naturally as rational. People that invest in a covered call buying a stock for $10,000 and collecting a $500 premium and invest the remaining $40,000 will be risking less than someone who sells a naked put, but invests the remaining cash. Of course the reason is, the put seller has to have $10,000 to cash if the stock goes to zero.

However, there's an even greater difference. In the event of a loss when the stock doesn't go to 0, the covered call seller experiences a paper loss; where as a put seller experiences a real loss. The covered call owner might put up $10,000 and that $10,000 suddenly is only good for $8,000 and all he has received is the $500 premium for the covered call. However, if this person has done the research and determined that the stock is undervalued, and is currently in a panic due to margin calls and forced selling, and that the fundamentals are good, the covered call owner still owns the 100 shares of the stock that they determined to be worth $140 at $100. Technically the put seller could choose to buy that same stock at $100 which is now worth $80, and put up the money rather than take the $20 per share loss. However, the covered call owner has likely researched the stock, has determined it to be undervalued and intends on owning this stock anyways. The put seller doesn't want to own this stock, instead expects the stock to remain neutral, and just wants to collect the $500. If the covered call owner was wrong, that means the stock goes lower than he expects, however that doesn't mean that the stock still wouldn't be undervalued even more so. If the put seller is wrong, the put seller will have to buy 100 shares of an $80 stock at $100. It may just seem like semantics, but the covered call owner already has bought the stock where as the put seller may not really believe he has to buy the stock. A put seller gets paid to buy the stock at a set price, where the covered caller gets paid to own the stock. Psychologically, it's a lot easier for a put seller to say "well I'm a good investor I think, my bet is probably right, I don't need to worry about the fact that the stock might drop in value because I don't think it will. I don't need to do more research, and oh, by the way, this extra $10,000 on the side, I can invest it elsewhere because I'm a good investor, and I'm not going to lose. An over confident put seller can lose everything in the account and then some with even a drop from $100 to $80, where as a covered call owner who is over confident will probably only lose a maximum of the amount he owns in that individual stock minus the price of the stock, and that's if the stock goes to all the way to zero.

In many ways they are a similar strategy betting a stock won't go up beyond a certain point, and that it won't go down beyond a certain point. But a person who writes a covered call will be forced to have the money to pay for it and on maximum in a margin account that person can only go on 2:1 margin. If a covered call buyer with $10,000 risked $20,000 they might need to transfer some money from their bank to their stock account and come up with $10,000

If someone sells puts, they are not technically on margin until a major loss occurs, however, if they sell 10 covered calls of a stock at $100 at $500 each, they risk losing $100,000 if it goes to zero. Put sellers most likely think that has a low probability of happening. Covered callers may think the same thing is true, the difference is, covered callers can never bet more than twice what they have even on margin, and most people won't go on margin anyways simply because they don't have the account set up to. Put sellers will usually HAVE to have a margin account to sell puts.

Selling puts requires a more sophisticated understanding as well, and when lost in the technical, I believe it's easier to forget about what you are betting on happening. If you sell an out of the money covered call, you are betting on it going down less than what you received for the option, or going up to the strike price (or higher, but gain is capped). If you already own a stock, it's easier to understand that you are trading upside potential for income, where as put sellers are risking money they don't have committing to buying a stock at a certain price no matter what betting that a stock will do the same thing essentially. But leveraged buyers and sellers are generally not the type that likes to have money on the sideline.

Naked call seller as are collecting income but if the stock goes up, they have unlimited risk since they do not own the stock that will cover them in case the stock goes higher. Selling a naked call could potentially result in unlimited margin. However in order for a stock to go unlimited gains, it has to have an unlimited amount of money put into it. This does not happen, especially to the largest of large cap stocks that are already heavily owned on heavily leveraged companies... However, large amounts of cash reserves still are needed, as large caps still appreciate in value, sometimes significantly. Being un-hedged and selling any sort of shares "naked" is not recommended. In theory there may be an identical hedged strategy, but in practice it just doesn't work out the same way. - 23212

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