Covered calls. How are they risky?

Z

zfmt

I was at a derivative event and a guy was saying how Covered Calls are really risky and anyone who thinks different doesn't know anything about derivatives. I have read about Covered Calls, I didn't think they were risky. Naturally, I didn't say anything. I just agreed with the guy because everyone else was (I didn't want to look like I don't know anything about derivatives.)

How are they risky? I thought the only risk is that you have potentially infinite opportunity cost if the stock sky rockets. But, I mean, that doesn't seem to be the risk he was talking about. He made it seem like an investor could lose all their money. I don't see how.

Was he just being dramatic? Or is there something I don't know?

I'm a little new to this.
 
You are right. He's wrong.

They aren't riskier than a buy and hold strategy. That is if you have an 100,000 account you do covered calls on <= 100,000 of notional.

What people tend to do if they have a 100,000 account is to do some kind of covered call strategy on 200,000. That is risky but only because of the leverage. Not because of the strategy.
 
Quote from zfmt:

. He made it seem like an investor could lose all their money. I don't see how.
More...

You buy XYZ at $10, write a CC with say, 11 strike, for $1. XYZ goes to zero, you keep your $1 but lose your $10 paid for XYZ. There's your risk, same as long stock minus premium received.
 
Covered call has same risk/reward as selling naked puts. If you can handle one, you can handle the other. If you're prone to over-leverage, neither one is likely to be suitable.
 
Quote from zfmt:

I was at a derivative event and a guy was saying how Covered Calls are really risky and anyone who thinks different doesn't know anything about derivatives. I have read about Covered Calls, I didn't think they were risky. Naturally, I didn't say anything. I just agreed with the guy because everyone else was (I didn't want to look like I don't know anything about derivatives.)

How are they risky? I thought the only risk is that you have potentially infinite opportunity cost if the stock sky rockets. But, I mean, that doesn't seem to be the risk he was talking about. He made it seem like an investor could lose all their money. I don't see how.

Was he just being dramatic? Or is there something I don't know?

I'm a little new to this.
More...

The guy is correct! Well, for the most part. Covered calls = put selling. Risk is always that the stock you intend to buy or currently own will plummet OR your stocks rocket much higher than your short calls and you're capping your gain at that strike. This is a wonderful way to collect a basket of losing stocks and a great way to lose a lot of money. try something else, maybe a collaring strategy.
 
Quote from Random.Capital:

Covered call has same risk/reward as selling naked puts. If you can handle one, you can handle the other. If you're prone to over-leverage, neither one is likely to be suitable.
More...
And of course, same potential downside as being long stock.
 
Ah, okay, thanks.

Yeah, I wasn't sure so basically, the only way to lose all your money with a covered call is to either leverage and lose or have the underlying stocks lose all their value. So the risks that are exclusively because of the covered calling are based on losing the appreciation on a stock that unexpectedly sky rocketed - I consider that an opportunity cost.

If I'm wrong I'd appreciate clarification. But if not, thanks for the answers guys!
 
Quote from zfmt:

I was at a derivative event and a guy was saying how Covered Calls are really risky and anyone who thinks different doesn't know anything about derivatives.
More...

Do you think it's a good idea to write a covered call against a growth stock during a screaming bull market?

Do you think it make sense to write a covered call against a biotech stock that's waiting NDA approval after a wildly successful phase III trial?

The answer for both should be obvious, because a covered call is not a universal strategy -- it makes sense for certain situations, but not all of them.

By making a blanket statement, that all covered calls are risky, makes it pretty clear that he's a complete dolt.
 
A portfolio strategy of buying 'good' stocks and writing covered calls on them while tauted by many a 'conservative' amateur is not a good idea.

http://www.callwriter.com/?gclid=CM3Z_OPPyasCFdY55QodH1_5zw

It caps your upside and leaves your down side open. The best of your 'good' stocks will be called away before they make you any significant money while the mistakes will accumulate in your portfolio. This will deteriorate your portfolio's net worth. Think about a portfolio of 'good' stocks with GE in it that you bought in 2007:

http://finance.yahoo.com/q/bc?s=GE&t=5y&l=on&z=l&q=l&c=

It would take a lot of covered calls to make up for the 50% haircut in that one mistake... and even more if you paniced on GE and sold at the bottom.

If you are going to cap your upside you need to cap your downside as well... e.g. writing call spreads instead of covered calls.
 
You must log in or register to reply here.
Back
Top