Q&A
Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. | 
Tom Gentile of Optionetics |
COVERED CALL STRATEGIES
With the market at yearly lows and the volatility of most options at yearly highs, I think covered calls would make a great strategy. I know you don't like to do them because of the high risk, but with stocks down some 90% from their 2000 highs, the risks are definitely less than before. What do you think?-- Rick F.
I can't disagree with you. Hindsight tells us any bullish strategy now is going to have less risk than it did two years ago. First, I'll describe covered calls for the folks out there who don't know what they are. Then I'll take a case study and look at it, along with an alternative.
In a covered call trade, you are buying shares of the underlying stock and selling call options against them. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. The technique allows traders to handle moderate price declines, because the call premium reduces the position's breakeven. Since you are counting on the time decay of the short option to render the short call worthless, you do not want to sell a call more than 45 days out. However, since the profit on a covered call is limited to the premium received, the premium must be high enough to balance out the trade's risk. Figure 1 illustrates the advantages a covered call offers compared to simply purchasing stock.
Philip Morris is trading at 40. You like the stock to the upside, but want to add some protection, so you decide to trade a covered call on MO. For every 100 shares of MO you buy, you sell one December 40 call for a premium of two points. Your cost for this trade is $3,800 ($4,000 - the premium $200).
The questions to ask now are: What is the risk, what is the reward, and what is the breakeven at expiration? The risk is still going to be $3,800, or the entire cost of the stock. The chances of losing all your money on a stock might be slim, but it could happen. Why didn't you lose $4,000 on this trade? Because you took in $200 of premium. Each month, covered call traders attempt to sell more premium, thereby reducing the cost basis on their trades. However, there is a better way to do this without the risk of the stock.
To synthetically create a covered call, you can use a deep in-the-money (ITM) option as a surrogate for the stock. A diagonal spread involves buying a longer-term Itm option and partially financing it by selling a shorter-term out-of-the-money (OTM) option. Let's say MO was trading at 40, and you were bullish on the stock for the long term. An example of a diagonal spread on MO might involve buying the July 30 calls and selling the December 40 calls. One has nine months to expiration (July), and the other one has two months to expiration (December).
Figure 1: COVERED CALL. Here are the advantages that a covered call offers in comparison to simply purchasing stock.
Why would you do this? There are a few reasons. First, you may be bullish on this stock, but think the long term offers better opportunity for it to move up. Selling the nearer option will lower the cost, but still give you unlimited reward once the short month expires. Another reason is time value. Time value in the front-month option (December) will drop much faster than in the longer-term option (July). So the stock could sit still for a month or two, and you could actually be gaining value in the spread. Breakeven will vary between the covered call and the diagonal, mainly because you are buying time when you use the option instead of the stock. Going deep in-the-money will take out most of the time value, however.
Here's the other plus: Total risk is confined to the price of the diagonal, so you know your worst-case strategy, and here the risk is much lower than it would be if you owned the stock and were selling calls against it. In this case, risk on the diagonal is now just $850, versus $3,800 on the covered call.
With a diagonal strategy, if the stock goes up, I win on my long call and lose on my short call. If the stock goes down, I win on my short call, and lose only the value of my long call. That's not so bad. It's the time value that really helps out both the covered call and the diagonal trade position. Note the differences between a covered-call spread graph and a diagonal spread risk graph (Figure 2).
Figure 2: BULL CALL SPREAD. Note the differences between a covered-call spread graph and a diagonal spread risk graph.
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Originally published in the January 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
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