(07/08/13) Pros and Cons of Covered Calls

Alan Ellman outlines the pros and cons of a covered call strategy, while stressing the importance of having a plan ahead of time.

My guest today is Alan Ellman. He’s the president of the Blue Collar Investors Corporation. Welcome, Alan, and thanks for being here.

Glad to be here. My pleasure.

Let’s talk a little bit about covered call writing, which you are an expert at. Can you tell me, for the average investor, what would be some of the advantages and disadvantages of using that strategy?

Sure. Well, I think the main advantage is that of all the low-risk strategies available to us, if you master the strategy of covered call writing, you can get the highest returns, higher than all other low-risk strategies.

Now, another one is the amount of control that you have regarding the outcome. What do you do if the price of the stock starts to decline after you enter your position? What do you do if the price of the stock goes way up? What do you do, for example, if on expiration, the price of the stock is higher than the strike price that you sold?

There are ways of mitigating losses, enhancing gains, and dealing with all these scenarios. In other words, if you master all the nuances of covered call writing, you will have an incredible amount of control regarding the outcome.

What are the disadvantages, then?

Well, that’s one advantage. There are many others. One of the disadvantages is that the profit potential when you have a covered call position is limited to the strike price.

Let me give you an example. You buy a stock for $48. You sell the $50 call. You generate, let’s say, a 3% one-month return...so far so good. Now let’s say some kind of unexpected good news comes out about that company—for example, FDA approval of a drug, a stock split, or a dividend distribution. The next thing you know, the stock is headed to the moon. It’s $60 in a week.

You’ve got to get rid of it.

You’re obligated. Exactly right. You’re obligated to sell it at $50, but the price of the stock is $60. You’d like to get your hands on those ten points, but you can’t because of your option obligation. Now, that being said, in a scenario like that chances are you’ve generated anywhere from a 5% to 8% one-month return.

I think it’s important for all retail investors to identify the strategy that they’re using—in this case covered call writing—and identify what their goals are for that strategy. In my case, it’s 2% to 4% a month for my initial returns. Then if you’ve met those goals or even surpassed them, be happy with that. Don’t say to yourself...

I could have, would have, should have.

If I used a different strategy, I could have done even better. Be happy with those returns. Covered call writing is a conservative strategy, and you have to be willing to hit those singles and doubles and not look for that grand-slam home run.

Now, sometimes I’m sure you have made some mistakes. What are some of the biggest mistakes that investors make in covered call writing?

You’re right. Back in the early 90s, when I started teaching myself this strategy, I probably made all the mistakes. But I learned from them.

I would say the biggest mistake made by the average covered call writer is that he makes his decision based on the return of the option. Now, if you’re looking to get a major big return, that’s a mistake. Covered call writing is a conservative strategy.

If you get more than a 6% one-month return for an at-the-money strike, that means that there’s a lot of implied volatility in that option. Stated differently, the market is anticipating a big price change in that stock prior to expiration. It doesn’t dictate which direction that price change is going to be. So if it’s down, one trade can wipe out your profits for the entire month. Selecting a position based on return is a mistake, absolutely.

Now, another mistake is not being prepared with a series of exit strategies, how to manage your positions. A lot of covered call writers will buy a stock, sell an option, and then just wait for the end of the month to see what happens. That’s a major, major mistake because you could manage your positions such that your returns are not so-so but rather oh-my-God by using proper management techniques.

Let me throw one more at you, because I have this problem at all my seminars: many covered call writers start trading too soon, before they’ve actually mastered the strategy. For the average retail investor who has little or no knowledge about it, figure it’s going to take about three to four months to educate yourself.

Practice.

Practice, absolutely. Paper trade and then you have years and decades to benefit.