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The Truth About Covered Calls


They're not as conservative as you think.

One of the option strategies I often warn against more than recommend is the basic covered call. This may seem odd given that covered calls -- in which one buys underlying stock and sells a related call option -- remain one of the most basic and popular option strategies and is the bread-and-butter position for retail traders and money managers alike.

These are often applied to blue chip core holdings such as Cisco (CSCO), IBM (IBM), and Microsoft (MSFT). But they're also used in higher beta names like Apple (AAPL) or even biotechs like Amgen (AMGN) to harvest some of the higher premiums.

My basic beef with the standard covered calls is that the inherent bullish bias in the financial and money management industry has tilted the field toward promoting the strategy in a misleading fashion.

Risk is usually underplayed. Covered calls are often promoted as a conservative strategy and as a way to hedge existing long holdings. The fact is that the risk profile is essentially the same as selling a naked put. Yet the same people that would never think of being naked short on an option are perfectly willing to write calls against their portfolio in search of generating "income."

And just like with the naked put, the profits are capped at the strike price sold with the maximum being equal to the premium collected. But you rarely hear brokers espousing the benefits of an ongoing put-selling strategy as a conservative way to position for a market trending higher. More likely, investors are discouraged from such activity by trading restrictions or high margin requirements on the naked shorting options.

Some of this is simply due to the fact that most people carry a portfolio that's net long stock, so there's no additional margin, and selling calls would be an appropriate way to collect premium.

But I think there's a better way to employ this basic bullish strategy that will open up the profit potential and reduce the capital requirements. This should hopefully result in a better return on investment.

A Covered Call, Call

The alternate to the covered call would be two small twists.

  • Replace the underlying long stock with the purchase of an in-the-money Long-Term Equity Anticipation Security (LEAPS), or long-term call option.

  • Rather then selling a single strike call, short sell a vertical spread short for a credit.

Let's look at a broad market example using the Spyder Trust (SPY). With the SPY trading around $107, one can buy the January 2011 calls with a $90 strike for around $21 a contract or about $4 of time premium, but that basically translates into the cost of carry versus putting up the capital for purchasing the underlying shares. But in the short-term you're tying up less capital. Buying 10 calls would cost $23,000 compared with the $53,500, assuming 50% margin, needed to buy 100 shares.

A nearer-term spread using January 2010 calls can then be sold to create a covered position. For example, the $112/$116 call spread can be sold for a $1 net credit. The benefit of selling is that profit potential becomes theoretically unlimited because, as the shares rise past the higher strike, the position assumes a positive delta and gamma -- meaning it becomes outright long.

This also means one can sell a multiple number of spreads against the long LEAPS calls. So, if you own 10 LEAPS with a 2011 expiration, you could sell 20 of the 2010 vertical spreads. This would garner you a $2 net debit, similar to simply creating a one-to-one covered position using the $112 strike, but with the open-ended upside.

Looking at the numbers for an individual stock with Apple $202 and tightening up the time frame, one can buy the April $180 calls for $31 a contract and sell the December $200/$210 call spread for 4.50 net credit. Again, the size of the spread can be adjusted depending on your market outlook. For a stock like Apple, which could burst another 15% to 20% in coming months, less might be better.

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No positions in stocks mentioned.

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