this is a great way to get high yield income but with risk, small guys can play induvidual stocks also with a margin account

Covered Call Writing

Covered call writing is the most popular stock option trading strategy of individual investors.

It’s also the most widely misunderstood and misapplied.

The goal of selling or “writing” covered calls is to receive a safe high yield income. Unfortunately, people often end up getting a lower total return on their investments, and even lose money writing covered calls, by using this stock option trading strategy the wrong way.

Here’s how that happens. They purchase several stocks and sell covered calls against them. After a month or two, some of the stocks have gone up, some have gone down, and some have stayed the same. The ones that have gone up the most were called away. The ones that have gone down are too far below the original strike price to make selling covered calls worthwhile at that strike price. The total portfolio is worth less than before the covered call writing strategy was attempted because the big losses on the stocks still held exceed the limited gains on the ones called away.

This problem is commonly referred to as cutting off your flowers and leaving yourself with a portfolio of weeds. The stocks that went up were winners and you don’t own them anymore. The stocks that went down are the losers and you’re stuck with them now.

Applied this way, covered call writing can be a painfully effective way of sorting out the good from the bad, and keeping the bad!

Many a covered call investor has watched first with amusement then with grief as the stocks that got called away from him rocket to new record heights while he watches from the sidelines clutching the meager few percent income he received from selling the covered call options.

Likewise, it can be very frustrating to pocket a few percent option premium then watch as the underlying stock you own continues to fall. By the time the covered calls expire and you are ready to sell more for the next month, the premiums are so low they would barely cover the commission, and the prospects for you to ever “get out even” on that loser stock are very low.

What about the stocks that neither went up a lot or went down a lot but just stayed about the same? Actually these are the ideal cases, a covered call writer’s dream, stocks that pay a high yield from covered call writing but stay fixed in price month after month, neither getting called away nor dropping precipitously. Wouldn’t it be great if all stocks were like that?

The reality is no such stocks exist. Sadly, inexperienced covered call writers set up their portfolios as if they do. They hope all their stocks will either stay the same or go up a little, and if they go up a lot and get called away they think that’s OK too, maybe even better because they pocket a little extra money from the capital gain between the stock purchase price and the strike price of the call option.

You cannot consistently pick stocks that both have a high covered call option yield and a stable price. In fact the opposite is generally true. Only stocks with high volatility relative to the average stock are likely to offer high option yields. The really safe, stable, established, high-dividend paying blue chip stocks that tend to just track the market and not fluctuate widely are the ones that offer the lowest option premiums.

If a stock has a high yield for covered call writing, the first question you should ask is why that’s the case. In general there are only two reasons. Either the stock is extremely volatile and risky such as a speculative drug research company, or its prospects are perceived by many investors to be very positive. Now you might think that the difference would be simple to discern by merely examining the relative option premiums between calls and puts on the same stock. If it’s just a volatile stock they should be roughly equivalent, while if it’s a big winner the calls should be paying much more than the puts.

In reality, it usually doesn’t work this way because for every hot stock soaring to new heights there’s always a large group of disgruntled contrary investors chasing behind throwing away their money buying expensive put options hoping to outsmart the crowd by calling a top in this “overpriced” stock. In fact I’ve observed this happening so often during my investing career that it’s become an old joke.

So you can’t tell much by comparing the call and put premiums for a given stock because they both are typically high (or both low). Another reason for this is that there are complex option strategies that tend to make it so, but that’s a subject to be discussed elsewhere on this site.

What about the misconception that it’s OK for some of your stocks to get called away? This is like missing the forest for the trees. You can’t have a successful option-investing portfolio by limiting your gains on your best stocks and absorbing the full losses on your worst ones. If you are very careful the best you can hope for is to achieve a lower overall volatility for your portfolio at the cost of accepting a lower total return than you would have by just owning the stocks outright without selling any covered calls.

Now for the third possibility – the stock takes a big dive.

Remember that stock option investing is a zero-sum game. Options are limited-time contracts between a buyer and a seller. When the time is up and the option expires, there is a profit on one side and a loss on the other. When you buy a stock and write a covered call option, it’s unlikely that the person who sold you the stock and the person who bought the call are the same person. It’s not likely that someone is making the exact opposite bet that you are, by shorting the stock and buying the call. Yet it is very instructive and eye opening to consider such a hypothetical scenario.

Consider the situation where you bought a stock and sold the covered call because the yield was good, then the stock tanked leaving you with a larger loss on the stock than the few percent income you earned from selling the call option. Imagine if you had done just the opposite. You’d have a nice profit. We could even refer to this strategy as covered call buying, that is, shorting a stock and then buying a call option to hedge the short position. The idea would be that you’d be willing to pay a few percent for insurance in case the stock went up, but you’d be hoping the stock dropped enough to make a big profit on the short position.

Inexperienced option investors seldom consider such a strategy. First of all if a stock is expected to go down, they ask, why not just buy a put option? I’ll answer that in a minute, but first try to imagine yourself in the situation of our shell-shocked unsuccessful covered call investor, shaking his fist at the winner stocks that flew the coop leaving him behind, and shaking his head at the loser stocks he’s stuck holding. Maybe you don’t have to imagine, maybe it’s already happened to you! Of course nobody can predict the future and all of us have losses from time to time, but until you understand what’s really going on in the options market you’ll continue to be stunned by what happens to you.

By understanding why the opposite strategy does make sense, it’s easier to understand what happened.

Stocks don’t go down. They are put down. Short sellers drive them lower. If they just bought put options, it would have no effect on the stock price. So to drive it lower, they utilize short-selling of the underlying stock. Optionally buying calls to hedge can greatly reduce their margin requirement, especially on high-priced stocks, allowing them to short more shares with less money invested. Also, the stock is always more liquid than the options.

So are the enticing high returns from covered call writing only a myth? No, it is possible to win with this strategy, but you have to apply the strategy correctly within the context of proper stock trading as an income enhancement, not a standalone strategy. You also have to know what to do when the strategy goes bad.