beginners corner

Myths and Misconceptions about Covered Call Writing

There are certain fallacies and deceptions associated with covered call writing as there are with all investment strategies. I am the first to say that there is no one strategy right for every single investor. We must master the pros and cons of each strategy to determine if it is right for our families. This includes rejecting information that is inaccurate and misleading. In this article, I will address and clarify the reality of the five most common of the covered call writing myths.

 

Myth 1: Sell options that generate the highest returns

Please do not fall for this one. This would be the tag line for a late-night TV infomercial. At 2 AM we see John (in black and white with a scowl on his face) working eighty hours a week and still not earning enough money to support his family. Then he starts selling high-premium covered calls and subsequently shown with a smile and in color working five hours a week. By 2:15 AM he is at the side of his Olympic-style swimming pool adjacent to his multi-million dollar mansion sipping on a pina-colada. All you have to do is sell those 100% annualized return call options. The truth is that high-premium options are associated with high risk underlying securities. Option sellers are getting paid more to undertake more risk. Most of us selling covered calls are conservative investors with capital preservation a top priority and therefore should AVOID these options, not embrace them.

 

Myth 2: Covered call writing under-performs

If you don’t know what you’re doing, any strategy will under-perform. From a more positive vantage point, we can succeed at most conservative strategies if all aspects are mastered. Covered call writing is considered by many the most conservative option strategy. There are three required skills needed to succeed and out-perform: selection of the underlying security, selection of the most appropriate option and position management. If all three of these skills are mastered, we should out-perform all normal market benchmarks.

 

Myth 3: Assignment of our shares is an unacceptable likely outcome

I’m getting angry just typing these words. If there are tax issues there are ways of circumventing assignment. Let’s assume no tax issues for this segment. Those using this strategy have clearly defined goals: income generation, limited downside protection by the option premium and willingness to sell the shares at the strike price. All these goals can easily be met whether shares are assigned or not. This relates to our three required skills including position management. Share assignment can be avoided more than 99% of the time if that becomes one of our goals. The truth of the matter is that we are generally concerned about the cash invested in a stock, not the stock itself when using traditional covered call writing (as opposed to portfolio overwriting). Furthermore, if you subscribe to the BCI rule that we never sell an option if there is an upcoming earnings report, we are never in a particular stock position for more than two months in a row. This is why we highlight stocks with upcoming earnings reports in our Premium Watch Lists.

 

Myth 4: We are forced to sell winners and hold on to losers

Now I’m really boiling. Let me go throw some cold water on my face…okay I’m back. No one forces us to do anything. We are (almost) completely in charge, unexpected early assignment being the RARE exception. Even if early assignment does occur, we can always buy back the stock if it is in our best interest. We can hold on to winners if the strike is in-the-money by rolling the option. We can and should sell a loser, especially one under-performing the overall market. One of the advantages of covered call writing is the incredible amount of control we have in the outcome of our investments. Those who allow this myth to become a reality will also subscribe to Myth 2.

 

Myth 5: We should use covered call writing because 90% of all options expire worthless

This claim misstates a statistic published by the Chicago Board Options Exchange (CBOE), which is that only 10% of option contracts are exercised. But just because only 10% are exercised does not mean the other 90% expire worthless. Instead, according to the CBOE, between 55% and 60% of options contracts are closed out prior to expiration. In other words, a seller who sold-to-open a contract will, on average, buy-to-close it 55-60% of the time, rather than holding the contract through expiration.

So if 10% of options contracts end up being exercised, and 55-60% get closed out before expiration, that leaves only 30-35% of contracts that actually expire worthless as shown in the figure:

percentage of options that expire worthless

Option Expiration Stats

The big question is: of the 55-60% that get closed out before expiration, how often did the option seller profit, and how often did the option buyer profit?

Much of the answer would depend on the movement of the underlying stock(s). In a simplified example, pick any of the Dow components and suppose that from this day forward through expiration, the stock flatlined, neither moving up nor down. Any options out of the money would end up expiring worthless, and therefore the sellers of those options (both on the puts side and the calls side) would be the ones cheering their profits. Now suppose instead that we look at all of today’s out-of-the-money options in the scenario where tomorrow the stock jumps substantially and stays at those high levels until expiration. In that scenario, the puts that had been out of the money (and even some that had been in-the-money) would expire worthless, but a lot of the calls that had been out-of-the-money would now be in-the-money and the call buyers (not the sellers) would be cheering their profits. As a third scenario, suppose we look at all of today’s out-of-the-money options if the stock were to fall tomorrow on some catastrophic news. In that scenario, the calls that had been out-of-the-money (and even some that had been in-the-money) would expire worthless, but a lot of the puts that had been out-of-the-money would now be in-the-money and the put buyers (not the sellers) would be cheering their profits.

There are many reasons to consider using covered call writing but buying into the myth that 90% of options expire worthless should not be one of them.

 

Discussion

Just because we hear something over and over again does not make it fact. Politicians use this ploy all the time. As Blue collar Investors, it is our responsibility to discern fact from fiction.

 

Next live appearance

Milburn, New Jersey

October 13, 2015

6:45 PM – 8:30 PM

For information

 

 

Market tone

A disappointing monthly jobs report indicated unexpected weakness in the US economy caused a downturn in the market early Friday. This dramatically turned around by the close of the trading week. Global stock indexes were volatile due to weaker signals from two of the world’s largest economies. Wednesday marked the end of the third quarter, the worst for US stocks in four years, with the S&P 500dropping by 6.9%. International stocks performed much worse. This week’s reports:

  • Nonfarm payrolls rose 142,000 in September, while July and August’s payroll increases were revised down
  • The average monthly US employment gain from July to September was 167,000, far below the 18-month pace of more than 200,000
  • The jobless rate remained at 5.1% as labor force participation fell to 62.4%, the lowest since the late 1970s
  • Average hourly earnings fell by one cent to $25.09, 2.2% higher than a year ago.
  • The Institute for Supply Management (ISM) index of national factory activity fell from 51.1 in August to 50.2 in September, its slowest pace in more than two years
  • New orders, employment and imports all fell to just above 50, the threshold between growth and contraction
  • The Chicago purchasing managers’ index (PMI) dropped from 54.4 in August to 48.7 in September as production and new orders fell substantially
  • New orders for nonmilitary capital goods excluding aircraft, a key gauge of business investment plans, fell 0.8% in August, below a previously reported 0.2%
  • New orders for overall factory goods fell 1.7%
  • The National Association of Realtors’ Pending Home Sales Index was down 1.4% in August but up 6.1% from a year earlier
  • The S&P/Case-Shiller Home Price Index rose 4.7% in the 12 months ended in July, a slight rise from June
  • Exports of US goods fell a seasonally adjusted 3.2% to $123.1 billion in August while imports rose 2.2% to $190.3 billion. The resulting goods trade deficit grew 13.6% to $67.2 billion, according to the US Department of Commerce
  • US consumers spent another 0.4% more in August, after monthly gains of 0.4% in July and 0.3% in June
  • The price index for personal consumption expenditures, the US Federal Reserve’s preferred inflation gauge, was flat from July to August and up only 0.3% from a year earlier
  • The Conference Board’s index of consumer attitudes rose from 101.3 in August to 103.0 in September, above the expected 96.1
  • The “big three” US automakers all reported strong sales gains in September, with General Motors up 12%, Ford Motor up 23% and Fiat Chrysler up14%
  • Initial jobless claims rose 10,000 to 277,000 for the week ended 26 September
  • Continuing claims fell 53,000 to a 15-year low of 2.19 million for the week ending September 19th

For the week, the S&P 500 rose by 1.04%% for a year to date return of (-) 5.22%.

Summary

IBD: Confirmed uptrend

GMI: 0/6- Sell signal since market close of August 24, 2015

BCI: Maintaining a cautious but fully-invested portfolio of in-the-money calls and out-of-the-money puts.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

Tags:

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

19 Responses to “Myths and Misconceptions about Covered Call Writing”

  1. Jay October 3, 2015 4:41 pm #

    Alan,

    From my experience explaining covered call and put selling to friends:

    Myth 6: our accounts go up as soon as we sell options

    It takes newer sellers a little while to understand their accounts do not change at all. They get cash they can use immediately but assigned an equal debit that will go either way depending on how the underlying performs. Time decay helps our debits but price action controls. – Jay

  2. Barry B October 3, 2015 9:39 pm #

    Premium Members,

    The Weekly Report for 10/02/15 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  3. Carlos October 4, 2015 1:18 am #

    Alan,

    Curious who are buying the options we sell and why. Also, what if no one wants to buy our options?

    Thanks

    • Alan Ellman October 4, 2015 7:49 am #

      Carlos,

      Option buyers can be both retail and institutional investors who are either using options for speculation (betting on directional movement of the underlying) or hedging portfolio positions. Our positions should not be entered unless there is a minimum liquidity (open interest) level or bid-ask spread requirement met. Market-makers are required to create a reasonable market for the securities they are responsible for. Trading liquid options will not be an issue for us.

      Alan

  4. Roni October 4, 2015 12:38 pm #

    Dear Alan,
    I have noticed that you have removed the words “bullish on the American economy” from the BCI assesment for the first time in years.
    The American economy cannot prop the stock market alone anymore.
    Almost all the American companies are dependent on the health of the global economy.

    I am also fully invested since the Grexit was avoided, and I intend to continue, even if the market goes more bearish.
    I am selling ITM calls as you recommend.
    OTM puts are more difficult for me to manage (got burned by selling VRX $220.00 put recently) I don’t understand why this is so.

    IBD states confirmed uptrend, while GMI shows sell signal since August 24. I hope IBD is correct, but a 50% chance either way makes me very cautious.

    I wish everybody good luck for nest week – Roni

    • Alan Ellman October 5, 2015 7:37 am #

      Roni,

      I am still bullish on the US economy based on the economic reports I read and outline each week in our blog and premium reports. This has been my stance since the second quarter, 2009. The US economy has been unusually resilient despite the myriad of global issues over that time frame. Short-term whipsaws will occur but longer-term I am definitely bullish…just one man’s opinion.

      Alan

  5. Jim October 5, 2015 2:48 am #

    I trade CCs exclusively and most often with just two stocks. I usually trade in lots of 10, so most often have a significant amount of money invested in the two equities (currently AAPL and WNR). My strategy is to continually roll out and thereby reduce my cost basis. I trade one issue using weeklies and one using monthlies. I hold this strategy until the holding becomes so far in the money that I am able to close prior to expiration within $.05 of the strike price.

    Any comment on this strategy

    • Alan Ellman October 5, 2015 7:59 am #

      Jim,

      Without having paper-traded a strategy I am always reluctant to accept or reject it. I am happy to make some observations:

      1- Lack of portfolio diversification is a concern.

      2- Need clarification of position management techniques using during the contract period outside of rolling.

      3- How are ex-dividend dates managed for both securities?

      4- How are earnings report dates managed?

      5- Would you consider using ETFs to achieve better diversification and still have only two positions to manage?

      Thanks for sharing your strategy. In the BCI community we can all learn from each other.

      Alan

  6. Alan Ellman October 5, 2015 8:18 am #

    Running list stocks in the news: CALM:

    What does the bird flu have to do with our Premium Watch List?

    In March, Iowa (largest egg-producing state in the US) was hit with the avian influenza which wiped out 31 million chickens causing a pop in the price of eggs. Recovery will take another 1-2 years. This has benefitted Cal-Marine Foods, one of the largest producers of fresh eggs. In a recent Q1 earnings report, sales increased 70.9% year-over-year and net income rose by 416.2% EPS growth rose a stunning 421% Consensus estimates have been rising as well.

    Our Premium Watch List shows CALM to be in the Food/Beverage Industry currently ranked “A”, a recent price of $59.48, an upcoming ER date of 12/21/15, a Scouter rating of “8”, a beta of 1.27, a dividend yield of 6.60% and an ex-date of 10/26/15. Options have adequate open interest for near-the-money strikes.

    Alan

    • Roni October 5, 2015 11:24 am #

      Thank you so much Alan.
      I just traded CALM buy/write at $59.87 with CALM 10/16/2015 60.00C at $1.47.
      Beautiful ROO of 2.5%, annualized = 60% right ?

  7. Alan Ellman October 7, 2015 5:11 pm #

    Premium members:

    This week’s 7-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
    For your convenience, Here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:
    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  8. Amos October 8, 2015 2:31 am #

    I have so much faith in your system. Especially after seeing you speak and reading your books Just trying to stay motivated and rid myself of anxiety so I can practice. Just started reading to refresh my memory and it occurred to me that I don’t really understand the concept of downside protection. Maybe I’m confusing it with the breakeven. Does downside protection imply that even if the stock price were to drop by a certain percentage I would keep my entire premium? Could you elaborate? Maybe an example?

    Thanks
    Amos

    • Alan Ellman October 8, 2015 6:29 am #

      Amos,

      Downside protection refers to in-the-money strikes.

      Let’s set up an example:

      Buy BCI @ $32

      Sell $30call @ $3.00

      Intrinsic value (downside protection) = $2.00

      Time value (initial profit) = $1.00

      Initial profit = $1.00/$30.00 (cost basis is “bought down” by the intrinsic value) = 3.3%

      Downside protection (of that profit) = $2.00/$32.00 = 6.25%

      This means we are guaranteed a 3.3% profit if share value does not decline by more than 6.25% by expiration.

      Breakeven is always share value when trade is initiated minus total premium. In this case $32.00 – $3.00 = $29.00.

      Alan

  9. Alan Ellman October 8, 2015 6:52 am #

    Running list stocks in the news: PLAY:

    Dave & Busters Entertainment is an arcade/restaurant chain that went public in October, 2015. It operates 77 stores in the US and Canada. 2nd quarter total revenues increased by 19.8% year-over-year while same store sales rose by 19.8% compared to 5.7% last year. Earnings came in at $0.40 per share substantially beating consensus estimates of $0.23. There have been 4 consecutive positive earnings surprises, with an average quarterly earnings surprise of 33.7%

    Our Premium Watch List shows an upcoming ER date of 12/16/15, an industry rank of “B”, a Scouter rating of “6”, a beta of 0.89 and adequate open interest for near-the-money strikes.

    Check to see if this is an appropriate security for your portfolio for the November contracts.

    Alan

  10. Alan Ellman October 8, 2015 5:12 pm #

    CALM: Unexpected (mixed) early release of earnings caused decline in share value. I am retaining this equity in my current portfolio.

    Alan

    • Roni October 9, 2015 2:03 pm #

      I bought back the CALM 10/16/2015 60.00C at $0.15, and will retain the equity.
      I am planning to sell November calls soon.

      Good luck – Roni

  11. Rich October 9, 2015 3:06 am #

    Hi Alan,
    I’ve been reading your material and am very much interested in learning more and getting involved.
    I have done some trading in the past with not much success, and I am intrigued by the covered call strategy. One concern I have is since your upside is limited, and your downside is unlimited – premium, how does this balance out over time?
    In one of your videos, you said it is better to trade with a sheltered account. I understand that it would delay paying taxes.. Wouldn’t it be better to use margin in a regular account so you could double your return?

    Thanks,
    Rich

    • Alan Ellman October 9, 2015 6:34 am #

      Rich,

      Upside is limited by the strike price, true. This is the main disadvantage of covered call writing…we never hit that “grand slam homerun” But we do hit “singles and doubles” all the time. Downside is unlimited IF we do not employ exit strategies…this would never happen in the BCI community as position management is one of the 3 required skills to master this great strategy in which case it will balance out quite favorably.

      Margin accounts are appropriate for some but not for most conservative retail investors. In essence, we are borrowing money from our brokers to generate higher returns. Leverage can work in both directions and each of us must decide if we want to borrow money for investment purposes. Again, this is appropriate for some and not for others. Covered call writing, in general, is a conservative strategy for conservative investors, in my view.

      Alan

    • Jay October 9, 2015 2:37 pm #

      Hey Rich,

      Alan does a superlative job answering our questions so I can not add much, if anything. I doubt any blog host works as hard as he does!

      I suggest selling options in tax protected accounts first. I only sell them in my IRA. Selling them in cash accounts can create tax head aches.

      I have never been a fan of margin. I guess I grew up reading too many stories about 1929 :).

      Your total return question is a great one. In 2013 my buy and hold account clobbered my covered call account. But a monkey walking on a piano made music that year! The tables have turned since then.

      Seems wise to use a variety of strategies. – Jay

Leave a Reply

Optionally add an image (JPEG only)