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:
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.
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
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%.
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 ([email protected])