Covered calls. How are they risky?

e.g.
Compare going long GE today and writing a Jan '12 covered call at 15 to buying a 14 call and writing the same 15 call:

Long GE at 15.22....................................Long Jan '12 14 call
Short Jan '12 15 call for 1.56..................short Jan '12 15 call
Investment: 1366....................................Investment: 67
Price.........P/L..........................................Price..........P/L
09...........(466).........................................09...........(67)
10...........(366).........................................10...........(67)
11...........(266).........................................11...........(67)
12...........(166).........................................12...........(67)
13...........(66)...........................................13...........(67)
14............34.............................................14...........(67)
15...........134............................................15............32
16...........134............................................16............33
17...........134............................................17............33

The covered call is fine on the upside but not so good on the downside.
 
Quote from danshirley:

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.
More...

There have been studies that have shown that covered calls have beaten a buy and hold strategy over the long period. Only by 1% per annum. This is unlevered vs unlevered and doesn't account for transaction costs and taxes (which covered calls create many taxable events). The reason is that the lumps hurt, but they hurt you when you just long as well. The accumulation of small profits from calls not expiring in the money do provide some outperformance even when GE drops 50%.

The strategy really only underperforms in ripping bull markets, like 2009 and last quarter 2010. Then you will either lose money on your calls as you buy them back or you will get called away. Either way, you will have a lower relative purchasing power to buy stock to re-establish the strategy.

Personally, I tihnk that if you were to do covered calls systematically, it should only be on the index. The 50% gaps are less likely, the gaps up are less likely (no takeover spec, etc), and index vol is generally overpriced relative to single stock vol (adding a slightly more likelihood your calls will expire worthless).
 
Option trading is not one dimensional but an adjustment
vehicle.
The following link to a very successful option writer
with extensive documentation over the past years shows how to sell premium with a core group of stocks successfully . A 50% drop in CAT and recovery is documented as an example.

The important component is selection of the stock and the willingness ot be assigned at some point

http://www.fullyinformed.com/

cheers
john
 
Here is a direct link to the CAT CC example quoted above:

http://www.fullyinformed.com/cat-stock-rolling-covered-calls/

This is, as was stated, an active trading strategy and very different from simply buying a collection of good stocks, selling covered calls and holding on for dear life.

I have often done this same sort of thing on selected stocks that I was very comfortable with..e.g. CWT:
http://finance.yahoo.com/q/bc?s=CWT&t=5y&l=on&z=l&q=l&c=

and yes the CC does provide a cushion for some degree of decline and substantially ups income, but you really need that recovery to make up a big decline... and you also need a lot of judgement, experience and luck to make it through a difficult market.
 
Quote from zfmt:

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?
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The risk is in owning the underlying.

Because you limit the upside by writing the call, you have a poor risk/reward ratio - eg. limited upside potential almost all of the downside. In addition, unless you have better than average selection techniques, you'll end up with a portfolio by adverse selection. They'll take away (exercise) your quality stocks and leave you with the so so issues and crap.

Now that doesn't flat out mean that writing CC's is a bad strategy. It means that you employ it when you're neutral to mildly bullish.

Now that I've panned CC's, let me confess that I do some of them for income. I write1-2 month calls about two strikes ITM that provide 10-15% downside protection. On bounces, I'll buy some protective put(s) or bearish put spreads. If it's the same strike, it locks it in as a conversion. Sometimes I buy extra puts a strike lower instead. "IF" the UL jiggles around, I try to trade the components. But the reality is, I need the UL to cooperate and when it doesn't, I need to make some good decisions in order to win. If either of these is lacking, it's very hard to make a profit, let alone break even. And that's the key to all of this option stuff - good selection and timing.
 
Quote from Appleseed:

Option trading is not one dimensional but an adjustment
vehicle. The following link to a very successful option writer
with extensive documentation over the past years shows how to sell premium with a core group of stocks successfully. A 50% drop in CAT and recovery is documented as an example.
More...
Less than 100 delta written calls doesn't offset 100 delta stock loss so it's a reduce the pain strategy in a bear. In order to succeed with CC"s in a falling market you have to trade against the position/adjust or have the UL cooperate. On it's own, it's a loser.
 
There is no "mechanical" successful options strategy, meaning a strategy you can apply over and over without any consideration of the underlyings's price and the options' intrinsic volatility.

Options trading may offer you better risk control and more leverage, but only when you can correctly anticipate the underlying's price and the options' intrinsic volatility changes over a given period of time.

In a bear market, or when you're bearish on a stock you have no business selling covered calls, which is equivalent to selling naked puts.

Always draw the options strategy's graph to have a clear understanding of your potential risk and profit, starting from underlying at $0.00.

<img src="http://www.cboe.com/images/covered_calls.gif">
 
I just gotta toss something in here guys... just take your net position from a covered call, and then figure out where you are at each closing price come expiration. Takes 60 seconds.

Pay $55 for stock, sell $60 call for $2.00

Where are you at $55? $60 $70

Whare are youat $50, $40, $30.

That's all there is to it...

Don
 
Some great posts here. The easiest way of thinking of a covered call (when I learned) is to remember that it is the same exact position (when graphed out) as a short put.

If you have a stock at $100 and sell the $100 strike call at $4, it is the same as selling the 100 strike put at $4 naked. Do the math on paper and the light bulb goes on. AT LEAST THAT IS HOW I LEARNED IT I hope this helps... If not, I apologize. Roberto
 
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