Selling a covered Call - any downside ?

[fakka 0]

So a relatively newbie - not looking to get into complex option trades --- just using mostly for hedging/income.

Wanted to understand what the downside of this approach is ? i.e Am I missing anything.

==================

 

What is the downside to this option trade ? I cant really think of any except...

1) Stock goes to 0 - same as a normal stock ownership so no difference.
2) Stock doubles - you limited your upside.

PSX - trading at ~$56, yields 6.5%.

The Feburary 19 2021 (150 days) 57.50 call option is selling for around $5.60. (well two days back when I first looked at it)

So that to me means ..... If you bought 100 shares ... and sold 1 option at that price you would;

1) Collect 10% or $560 on your $5600 investment for 161 days.
2) Collect 161/365 days worth of dividend @6.5% ~ 2.87%
3) Collect if option is excised $1.50 ($57.50 call $56 stock price) also . 2.67%

So total for 161 days approximately

10% + 2.87% + 2.67% => 15% for less than half a year.
Or over 30% for the year.

Whats the downside ? Except what I mentioned above.
Any fault in my logic ? Looking to hedge a little bit of risk but stay in market.

 

 

[Kim 7,943]

@fakka Covered call is similar to naked put and it's a very good strategy that in many cases allows you to get similar returns to owning the stock with less volatility.

However, there are no free lunches. The most obvious downside is as you mentioned limiting your upside.

So consider the following scenario:

1) Stock goes up by $50. Since you sold a covered call at $5.60, this was your gain (plus the difference between the stock trading 56 and the strike, so total around $7).

2) Now you sell another call at similar price. The stock goes down $50 back to $56. The call protected you only by $5.60 (or whatever price was), so you lost around $44.

Your total loss is around $37 while the stock is unchanged.

The bottom line: this strategy is not performing well during periods of high volatility. You get only limited upside, but much higher downside if the stock starts to jump around.

[fakka 0]

@Kim 

Thanks kim

Sounds like I understand it correctly.
I guess it depends on how you define "loss".
In your scenario ....... I have lost out on the potential gain of $50 ($5000 on 1 option).
But from my viewpoint ..... 

I bought the stock at $56 ...... I sold two options at $5.60 ($560x2) or $1120 ..... and I still own the stock and collected the dividend.

Thats over a 20% return ...... and not much risk except the loss of bigger gains.

I can live with only 20% return ........ 

 

[Kim 7,943]

You are right, my example was not the best scenario to illustrate the risks. The main risk is this: when a stock goes up sharply, the covered call significantly reduces the gain. When it goes down, the gain from the sold call is not enough to offset the lost gain from the period when the stock went up.

Here is a better example from one of my old SA articles:

Why Writing Covered Calls On Apple Might Be A Bad Idea

 

[fakka 0]

@Kim

Thankyou Sir !! I dont have a SA Premium account - just regular - so its blocked.

 

 

[Kim 7,943]

Sorry.. here is the table that illustrates the AAPL scenario:




As we can see, the stock would produce a respectful 25% gain in the last 10 months. Selling covered calls would turn this gain into a 3% loss.

[fakka 0]

@Kim 

Thanks !!

How is the CC P/L calculated ....... eg at line May 18  - that looks like what we are saying is  stock went from $572.98->$530.38 So a loss of $42.60. But we received $28.77.

So a paper loss of $13.83.

So I think I get that from a monthly trade perspective ....... looks like holding the stock was better. But I *think* in my scenario Im looking more for income stream on a longer term basis.

meaning.

Normally I'd just buy a stock like PSX for income (dividend) at a certain entry point and accept the up/down volatility ..... and calculating that at sometime in future I'll sell for breakeven or higher on stock price ..... plus my 7% dividend. So lets just go with break even and a yearly 7% return.

but if I sell a longer dated covered call I have a few options.

1) If stock goes down ....... I'll receive the option strike gain as the option will expire worthless. Now making my cost basis even lower. Rinse and repeat. Still collect my 7%.

2) If stock goes up. The option gets called. I collected (in my example) an 20%-30%  return over the period of the year (annualized).  

 

Sorry - think I am just rehashing what your saying - which is your limiting your upside and your downside has no limit.  That's what the premium is for.

But if Im comfortable owning the stock anyway ...... then locking in a worst case 20% return on upside seems good. Downside risk to me is basically the same in either scenario (options or just stock) => 0.

Not looking to trade options apart from a hedge/defined income. Sometimes I will sell the covered call on a stock I want to own anyway based on technicals ..... stock looks overbought etc .... 

 

[vitalsign0 13]

I've run a few backtests and a Married Put will usually perform a lot better than a Covered Call. Married Put = buy 100 shares of stock + buy 50 delta Put 90 DTE. This gives unlimited upside potential and limited downside risk. Worked much better with AAPL than a Covered Call over the past 2 years. 

[Kim 7,943]

@fakka I think you need to look at the total performance, not just income. A gain is a gain, no matter if it comes from selling covered call, dividend or stock appreciation.

So overall, you are correct. As I said, I believe it's a good strategy overall - but we need to be aware that it's not a holy grail, and in some cases, just holding the stock might produce better results. So we don't really disagree - I'm just trying to show that there are no free lunches in trading, and each strategy has its advantages and disadvantages.

[fakka 0]

Thanks @Kim @vitalsign0 

 

@vitalsign0  "Married Put = buy 100 shares of stock + buy 50 delta Put 90 DTE"

Do you mean buy 50 units of put option (i.e 5000 stock total control) ........ at 90 days expiration out ? 

[vitalsign0 13]

18 minutes ago, fakka said:

Thanks @Kim @vitalsign0 

 

@vitalsign0  "Married Put = buy 100 shares of stock + buy 50 delta Put 90 DTE"

Do you mean buy 50 units of put option (i.e 5000 stock total control) ........ at 90 days expiration out ? 

Just 1 Put option per 100 shares. Then roll the Put option every 30 days. I ran AAPL through CML's Trade Machine backtest and the Married Put produced 3x the return that a Covered Call did for the past 2 years. I only think Covered Calls are good in retirement for producing a dividend like income on shares you've held for a long time. 

[fakka 0]

15 minutes ago, vitalsign0 said:

Just 1 Put option per 100 shares. Then roll the Put option every 30 days. I ran AAPL through CML's Trade Machine backtest and the Married Put produced 3x the return that a Covered Call did for the past 2 years. I only think Covered Calls are good in retirement for producing a dividend like income on shares you've held for a long time. 

Thanks.
What does the '50 delta' mean though --- sorry ---- that lost me.

[porgie 118]

1 hour ago, Kim said:

Sorry.. here is the table that illustrates the AAPL scenario:




As we can see, the stock would produce a respectful 25% gain in the last 10 months. Selling covered calls would turn this gain into a 3% loss.

Also depends if you are selling shorts right at the money of course.

 

If you sell the delta 30 calls instead I wonder if the performance would be better over a long bullish cycle.

 

Also if you are really bullish one could go with 1/2 ratio on the shorts---I wonder what the performance would be with 1/2 ratio at the delta 30 shorts, but then again I am drifting away from the discussion on "pure" covered calls.

[Marco 223]

1 hour ago, fakka said:

Thanks.
What does the '50 delta' mean though --- sorry ---- that lost me.

'50 delta' usually means an 'at the money' option. So strike = share price. (technically 'at the money forward' but thats further down option theory...)

further to the downsides already discussed you have a possibility that your short call gets exercised just before dividend (will typically happen if the stock has rallied a lot and the option doesn't have much time to expiry) so you don't earn the dividend in that case.

Having said that I had a portfolio with stocks that I liked and sold calls against that. Was lower vol stocks (energy, pharma, consumer staples, telcos, utilities etc) So idea was income generation from dividends and option premiums. You give a lot of your returns back if you hit a high vol period - something like the fast drop and recovery that we've seen between Mar and now is not great for that sort of strategy even if the spike in implied vol will increase your option premiums.    

[fakka 0]

@Marco - thanks - that makes sense

 

[t'pee 541]

Great discussion, I personally like selling covered calls on a portions of a significant holding of a business I am bullish on based on fundamentals and is undervalued. If I have a full allocation but the stock takes a hit (but the thesis does not) I will buy another 100 shares and a slightly OTM call option on an up day. I'll be happy to sit it out, collect divs and if it takes longer to recover I can repeat the process. The trade offs here (to Kim's point there's always a trade off):

1. My thesis is wrong (ouch) and I end up incurring permanent (or at least long term) loss on a full allocation, plus 100 shares

2. The stock rallies and I lose a lot of upside but this is precisely why I use extra allocation, I am still sitting on the rest.

It's increasingly amazing to me how many different ways there are to skin a cat (or get skinned) with options😉

 

[Dennis Wood 1]

Curious if anyone is familiar with Kurt Frankenburg, founder of PowerOptions.  He promotes using married puts and then building income positions off that core structure.  For example, one of his income methods would be to sell a ratio spread rather than the standard covered call.  The call that is usually naked within the ratio spread would be covered by the 100 shares within his core married put structure.  This would leave him with a vertical call spread.  So he has protection to the downside with the married put and a riskless vertical call spread to the upside.

[tbtf 45]

I was playing around with Kurt's style of trades recently. The idea is to buy a stock you are keen on and then also buy a deep ITM long term married put so that you don't have to pay too much for the extrinsic portion of the put. Your risk is then limited to the amount you pay for the extrinsic which is typically 7%-10% of the cost of the stock and the put. The trade off is obviously that the put acts as a drag on any increase in the stock price.

However, his key trick is then to sell various short term options (covered calls, ratios, etc) in order to pay off the extrinsic part of married put and get to a risk-free status. Or, and this specifically appealed, use the dividends to pay off the extrinsic value over time.

Sounds good from a risk point of view but I wasn't convinced on the reward side of the equation. Here is the published track record.

https://www.radioactivetrading.com/ptrackm.asp?pid=12 

[Dennis Wood 1]

Thanks @tbtf I did get the impression that it would be a slow grind, maybe something to have working on the side in an IRA.  As is usually the case in these matters, Kurt likely makes more money selling the process (The Blueprint) rather than using the process itself.  Still, some good ideas and tactics can be learned from this I think.  I'm debating to implement this married put core strategy using synthetic longs (buy ATM call sell ATM put) so that I can use a smaller account with it.  The cost of the synthetic long itself is minimal, and the purchase of the ITM married put would cut down what is usually a very large margin requirement.  

[tbtf 45]

I ended up plumping for the anchor strategy after assessing the different approaches available for really minimising downside risk. Keeping it in house!

[Kim 7,943]

8 hours ago, tbtf said:

I was playing around with Kurt's style of trades recently. The idea is to buy a stock you are keen on and then also buy a deep ITM long term married put so that you don't have to pay too much for the extrinsic portion of the put. Your risk is then limited to the amount you pay for the extrinsic which is typically 7%-10% of the cost of the stock and the put. The trade off is obviously that the put acts as a drag on any increase in the stock price.

However, his key trick is then to sell various short term options (covered calls, ratios, etc) in order to pay off the extrinsic part of married put and get to a risk-free status. Or, and this specifically appealed, use the dividends to pay off the extrinsic value over time.

Sounds good from a risk point of view but I wasn't convinced on the reward side of the equation. Here is the published track record.

https://www.radioactivetrading.com/ptrackm.asp?pid=12 

You are right, the downside is very small (depending on the strike you buy), but the upside is limited as well - you need the stock to increase in value by the price of the put just to break even. So the stock can go up 20-30% and you are still up only 5-10%. As usual, there is a tradeoff to any strategy.
 

7 hours ago, Dennis Wood said:

Thanks @tbtf I did get the impression that it would be a slow grind, maybe something to have working on the side in an IRA.  As is usually the case in these matters, Kurt likely makes more money selling the process (The Blueprint) rather than using the process itself.  Still, some good ideas and tactics can be learned from this I think.  I'm debating to implement this married put core strategy using synthetic longs (buy ATM call sell ATM put) so that I can use a smaller account with it.  The cost of the synthetic long itself is minimal, and the purchase of the ITM married put would cut down what is usually a very large margin requirement.  

It is true that synthetic stock requires less margin, but I would be very careful to base the position sizing on margin and not the stock value.

For example, to buy AAPL stock, you will need $13,300. So lets say you have 13,300 portfolio and buy 100 shares, no leverage.

Now lets say you buy a synthetic position that requires only $3,300 margin. If the stock declines to $100 (25%), your loss is $3,300 or 100% on margin. If you purchased 4 contracts in your $13,300 portfolio (which you could do based on margin), your account would be toast.