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Is Covered Call Writing Risky?

Posted by Pete Stolcers on May 30, 2006

Option Trading Question

Ravi D. submitted the following,”I have found covered call writing on bio techs to be risky. How do you screen for candidates?”

Option Trading Answer

First of all, I agree with Ravi’s observation, bio techs are a risky “buy-write”. This term is used when someone buys the stock and immediately writes a call against it. The end result is a covered call position, however, let’s not confuse this strategy with the investor who has owned a stock for many years and wants to generate income and add a little protection by selling a call against it. In Ravi’s case he has entered the position with the intent of generating income and possibly a small gain. In the later case, the investor bought the stock with a long term goal of capital appreciation(assuming the stock does not pay a dividend).

There are a number of “so called” covered call search engines that will find the “most attractive” candidates. I have seen many traders crash and burn using this method so I feel that it’s important to address this question. Let’s say that the search returns a stock that trades at $17.50 and the front month calls trade for $1.50. Let’s also assume the stock pays no dividend. On the surface, the trader rationalizes that if the stock stays flat or goes up he will make $1.50 on a $16.00 investment ($17.50 - $1.50). That will yield a nice 9.4% return in a month if it works out. What’s more, the stock can even drop $1.50 and he will still “break even”. These search engines focus on near term options because that is where the highest returns are found. Taking advantage of front month time premium decay is wise in most cases, but there may be a greater issue here.

A week later, there is a news item and the stock is down $5 to $12.50. Now he is down $3.50 or 22%. At this juncture the trader starts to investigate all of the news. Low and behold, there was pending litigation and the verdict was announced. These scans look for options with high implied volatilities (IV’s) and they don’t account for news. The volatility does not appear out of thin air. Someone bought that premium (it could have been both the puts and calls) and alerted the Specialist or DPM (Designated Primary Market Maker) that something was up. As the buying continued, the Specialist/DPM backed off until the premiums were sufficiently high. This resulted in high implied volatilities and there wasn’t even a move in the stock. It could have been the Specialist himself that was aware of the release date and the weight of the decision. To buffer his risk and adjust his reward for the news he raises the IV’s without and option even trading. It’s his business to know. The point is that high premium exists for a reason. It is not some buried treasure that has escaped everyone but you.

In other instances, the stock may just be very volatile and the premiums are normally high. If I have done extensive research, I like the stock and I’m willing to assume the risk - the trade may make sense. This will often be the case when a good stock has been “taken behind the shed” and it looks like a good value. I evaluate the stock’s support and resistance levels and I subtract the proceeds of the call I sold to calculate my net cost. The key to my approach is I look for the stock first. I want to own the stock and I’m willing to sacrifice some upside in return for a little protection. In the event that I find a nice stock that has not been wild, I look at historical IV’s to make sure there has not been a recent increase. If the IV’s have increased for no apparent reason - I won’t do the trade. That is common when an option spans an earnings release date and the front month is expensive relative to the next month out.

If there is any kind of scheduled (earnings release) or anticipated news event, I will avoid this strategy like the plague. I’m paid to predict price movement, not to gamble on the unknown. I don’t have the research to compete with the “big boys”. There is no logic in capping my upside on a wild stock and assuming virtually all of the downside risk. This strategy needs to be handled with great care when high IV’s are concerned. One bad trade can wipe you out.

Focus on the stock, not the premiums for this strategy.

Now you can win by answering my question. Instead of doing a buy-write on a stock stock that does not pay a dividend, what would be an equivalent, more efficient approach and why? The best answer gets a free one month subscription to the OneOption service of their choice.

Option Trading Comments

  • On 07/11, Kurnia Dharmawan said:

    Pete,

    Yes, I agree with choosing the right stock for covered call writing. It is a conservative strategy, yet if we choose the wrong stock it can wipe out the profit.
    I had bad experiences when I wrote NUE last month. It is a good stock however when it gap down from 66 to 56, it really tested my psychology. Despite I know that the stock will rebound (as it is now), but I cut loss at around 57 and walk away with LOSS. Quite a hard experience....
    BTW, I am one of your fans reader. I used one of your topic about volatility to explain at my blog (bahasa Indo version). I did mention your name and your experiences as a trader to the readers......

  • On 07/17, James Larson said:

    I am totally out to option trading. But this gave a great overview.
    http://www.theclickdepot.com/internet-marketing-services.html

  • On 08/30, Thomas Lee said:

    "Instead of doing a buy-write on a stock stock that does not pay a dividend, what would be an equivalent, more efficient approach and why?”

    Selling a naked put or a put bull spread would be a more efficient approach because there would be less transactions if the market moves in your favor.

  • On 09/02, Mark said:

    What are some search engines for researching Call Bid prices? I am generating income on covered call writings and I need more data with less leg work.  thanks

  • On 09/09, Pete Stolcers said:

    Hi Thomas,

    The bull put spread is more efficient in one respect. The margin required is much smaller than the naked put and your return on capital would be higher. However, when people do bull put spreads, they leverage up and that is no longer an apples to apples comparison to a buy-write.

    The naked put write on an unleveraged basis is a more efficient approach to covered call writing because the commissions are smaller and other securities can be pledged to cover the margin requirement.

  • On 09/09, Pete Stolcers said:

    Hi Mark,

    If you are simply looking for rich premiums for covered call wirtting - good luck. I have seen more accounts blow out that way. The high IV is not there by mistake. The Market Makers know there is uncertainty and they juice the options to adjust for risk.

    Start with stock analysis (technical and fundamental). When you find a good candidate, then analyze the options.

  • On 09/12, Alex said:

    Although it’s not strictly equivalent to a covered call, a put ratio spread could be more effective if you are slightly bullish as is usually the case with covered calls.  Even though it’s not a purely directional strategy, at least you won’t lose money if the stock doesn’t drop below the break even point.

  • On 09/12, Pete Stolcers said:

    That is certainly an alternative and it takes on the look of a collar (long stock, short call, long put).

  • On 09/16, Gregs said:

    Covered call strat is really my main strategy in my IRA account.  And for the most part 70-100% of my IRA will be invested in one stock that pays a dividend and I Sell covered calls against it(or pickup shares with naked puts).  The stocks I buy in my IRA are things like GE,X,NEM, APC, etc.  Not huge premiums received, but a solid 1-2% a month + dividends smile Would like to hear anyone else’s dividend plays that they recommend.

  • On 10/10, Rich Locasso said:

    Hi Pete-

    Great topic, thank you. I’m new to options and have been studying and paper trading for about 9 months.

    It’s my understanding that IV is the only subjective parameter in the options pricing model. As such MM’s set the value. It is called IV and is supposed to address volatility. But there is nothing to prevent it from being adjusted for any MM reason or purpose.

    MM’s do not know everything. Adjustment could reflect MM uncertainty, angst, lack of knowledge, rumor, etc. Maybe they adjust to influence supply, demand, balance of their holdings. The price goes up but there may be no fundamental reason for it.

    I have been experimenting with calendars, diagonals and iron condors with biotechs that are channeling. I look at tons of option return values. Some as noted above are nose bleed high and indicate pending decisions that will gap the stock. Like you say, avoid those for sure.

    However others are to me in a “sweet” range, maybe 45% to 65% return annual. Here I wonder if the slightly elevated IV is not related to anything concrete other than temporary MM discomfort, angst or “itch” as stated above. This can maybe go away over time. But it inflates IV and creates temporary and attractive buying opportunities. 

    If all other factors are acceptable I jump on these because one can write a much nicer spread and with attractive potential return.

    I’m learning here. Is there any merit to my impressions outlined above?

    By the way, I’m learning that one needs to monitor the portfolio daily and in detail to stay on top of biotech stocks!  Thanks again,

    Best,
    RichieRich

  • On 10/13, Pete Stolcers said:

    MM’s do adjust IV. If traders feel that it is unjustly high, they will come in and sell options to get the price down to where it belongs. It would be very dangerous for MM’s to arbitrarily assign a high IV, there is always a reason.

    MM’s might not know the outcome of a pending event, but they are aware of the event. Most market making is conducted by large institutions, not individual traders. Research teams try to evaluate the probability of each potential ourcome and the associated price movment. Base on their analysis, they can determine the appropriate IV.

    Yes, if the stock normally carries a high IV and you can form an opinion bullish or bearish, selling out of the money spreads can be very effective. Just watch out for situations where the IV is very high relative to the historical IV for the options over the last year.

  • On 11/02, Jonas said:

    Hello Pete,

    I don’t know if this is super late but I want to take a shot at your “riddle” if no one else got it right. unless someone did and i missed it o.O

    but would the answer be something like an ITM Diagonal Spread?

    First you buy an ITM call some months out (back months). Then along the way you sell front month OTM calls collecting premium. If the stock goes up your call goes up.
    If it goes down, since your call was in the money it’s got some umph to it and wont completely collapse because there’s still some months to recover.
    And since you bought ITM, little gains would still give you a profit so you could leave any time after it goes up.

  • On 11/03, Pete Stolcers said:

    Hi Jonas,

    The good news is that you got the right answer. The bad news is that it was about 2 years late. Yes, a number of readers got that right.

    The key is to buy an option that does not carry a lot of time premium. It will move with the stock. Sell the OTM front month option and generate income. If the stock rallies, you will be able to sell the longer term ITM call and buy back the front month call at a profit. If the stock stays flat or moves a little higher, the front month premium will decrease the cost of the longer term call. Then you repeat the process.

    Two things to remember. You have to like the stock long term and it has to have strong support and be in an uptrend.

    Secondly, make sure the longer term option does not carry a lot of time premium. If it does and the stock rallies, you could actually lose money if the short term call goes way in the money.

    Thanks for the reply.

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