Covered Call writing

Some would say that up to 80% of issued options expire worthless. At first glance it must seem like a 'no-brainer' that the 80-20 ratio guarantees profit from selling 'naked' options. There are other factors that seem enticing when considering selling options, the Options extrinsic value decreases exponentially over time. However there is no such thing as a free lunch.

There may be a small chance of loss but the losses can be unlimited, conversely, there is a greater chance of profiting, but the profit is capped to a smaller amount. Therefore the risk / reward ratio is skewed. It would be great if there was a way to hedge that small chance of a wild market move wiping you out.

There are some strategies that can limit losses, one of these is a spread which basically entails buying a long option position that offstets a portion of a potential loss. Unfortunately spreads can be costly to implement.

Covered call writing, another strategy that we have covered in the past, is a gentler way to capture option premiums with limited risk. It is a way of increasing overall return on shares owned by the investor. The strategy involves selling a call short against a long position held in the underlying asset. Therefore the risk to the short call position is 'covered' by being long the stock.

In theory, coverered call writing sounds perfect, and as this example of covered call writing in practice shows it can produce the desired results. But there are pitfalls and downsides that an investor should be aware of;

Covered calls are best written on stocks are trading in a range, such as a channel. Therefore your underlying long stock position is less likely to be excercised. Couple this with the contradictory aspect of volatility (demonstratd by Bollinger bands) that makes the premiums more attractive to the seller.

The call option premium is usually too low to be attractive to sell if a stock is trading sideways and volatility is low. For example, why would you want to limit the growth potential of stock that you hold if the only option you could sell would be less than the potential gains in the stock price. In a worse case scenario if the share price falls the small premium you received for the call option sale is not much of a cushion, and brokerage costs in exiting the call options can further add to the loss.

Conversely, a very volatile underlying stock will have a high premium on the options. The downside is that if the share price increases there is a likelihod that you may get exercised. Before that happens, will you exit the whole trade before expiration? would the option premium decayed enough to leave you with some profit, or has the volatility increased so you have to buy back the short option at even more of a loss than the intrinsic value?. If you wait until expiration your money is tied up in a dead-end trade where there is little upside. Do you take a loss on the short call option, hold onto the stock, and hope the stock keeps going higher? And where do you put a stop on the underlying stock if it starts to decline, especially below your breakeven point?