Sometimes your option trade can be 100% on, and yet you still feel a twinge from a missed opportunity. I was reminded of this paradox when reading a forum post from TK client Spencorama, who writes: “Selling covered calls and/or [buying bull] call spreads are two of my major strategies. CC's can be a little painful if the stock is rising quickly so one has to be pretty nimble about when to roll up, buy back, or simply let them ride all the way to expiry, especially when they are close to the strike.”
Spence,
One of the truths about trading options is that there is no “best” way to look at positions, and different investors have different goals. At the same time, your stance on covered calls here is a little puzzling. Let me see if I get you thinking differently about this.
When you write a covered call, you’re making a trade off: in return for accepting a limited upside profit, you are paid a cash premium. Specifically, your max potential profit is limited by your obligation to sell shares at the strike price, but you also get to keep the premium received for selling the call. That cash increases the probability of turning this position profitable (counting from the day you write the call), plus it offers some protection against a decline in the price of the shares. Those are both good attributes for a position.
What’s your max potential risk with a covered call? It’s the downside risk of owning any stock, which can decline to zero. However, your comment points out another risk: the “opportunity risk” that the stock could skyrocket. If that happens, the calls will probably be exercised by its owner, and you will not participate in any stock price increase above the strike.
In my opinion, when you write a covered call, the best thing that can happen is to see the stock run through the strike price, and to be assigned an exercise notice at expiration. That scenario yields your maximum profit. How can you beat that?
That you find the prospect of earning the maximum profit on the position to be “painful” suggests you’re thinking more about what might-have-been with your stock position than about the actual, good news on your covered call. If it’s truly painful to see the stock rise too far, then writing covered calls is not for you. In addition to making trades that suit your market outlook and risk profile, you should try to make trades that are psychologically satisfying. But when the maximum possible profit was earned on this covered call, you were far from satisfied.
Why own a bull call spread instead of a naked call? You probably know the reasons: a naked long call is an unhedged position in which you could lose 100% of the cost of buying the call. A bull call spread, on the other hand, is a hedged position where your risk is limited to the debit paid to establish the position. In exchange for limiting risk, with this play you accept a ceiling on your max profit: to be specific, the difference between Strike A and Strike B minus the net debit paid. That’s essentially the same idea as writing covered calls: less risk, less potential profit.
(Keep in mind that spreads are multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Keep the risk of early assignment in mind when constructing your own trades. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.)
There are advantages that come with turning a naked long into a hedged position. Isn’t that a good enough deal?
I’m not telling you to never make an adjustment, but I think it’s a mistake to make avoiding assignment your top priority when writing a covered call.
Here’s a suggestion: if you’re truly bullish on the underlying, make the equivalent trade, instead of writing a covered call. Consider selling cash-secured puts instead. The put has the same strike and expiry as the call you would be writing. As to size, sell just as many puts as you would have sold calls. (Brian Overby, TK’s “Options Guy”, just wrote a post on this, The skinny on cash-secured puts).
The reason cash-secured put selling should work for you is than when the stock rises, the price of the put shrinks. You will be making money when that happens, and you never have to be concerned with not earning enough profit. If the stock tumbles, you are no worse off than if you had written the covered call.(Again, the max potential risk in a covered call is actually the downside risk associated with owning stock, which can decline to zero.)
Taking this approach to the trade will probably feel different to you – but it rests on a similarly neutral-to-bullish outlook.
Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
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