by Gregory Spear, editor
The Spear Report

       One of the first strategies that a new options trader hears about is the covered call play. Frequently this strategy is touted as a safe and simple way to make money with options. Many brokers allow covered calls as the only options trade that can be made in a retirement account because it is "conservative."
       Unfortunately, categorizing covered call trades as "conservative" is highly misleading. Ask those brokers who only allow the trading of covered calls in retirement accounts how they feel about the selling of naked puts, and they will explain how that is much too risky to be allowed in a retirement account. Well, at least they got that part correct - selling naked puts does involve significant risk.
       Would you believe that a covered call trade carries essentially the same risk as selling a naked put? Later I will demonstrate why this is true. Nevertheless, I don't want to completely dismiss the covered call strategy. It can work provided you understand the risks and learn how to evaluate this type of trade.
       Let's first look at an idealized scenario of the covered call strategy working to perfection. You buy 100 shares of XYZ at $30 per share for a total investment of $3,000. Over the next seven months this stock averages a monthly rise of 9.5% as it moves up to $50 per share for a great $2,000 profit. To enhance your profit in each month along the way, you sell 1 call option contract (one contract = 100 shares) on XYZ at a strike price that is about 10% - 15% above the stock price. These are referred to as "covered calls" because they are secured by your stock in case the option is exercised, thereby requiring you to sell 100 shares of XYZ at the strike price.
       Suppose that your selling price for each covered call is $1.50 per share, which brings in an additional $150 per month. Assuming that the price of XYZ is never above the strike price of the current month option as it expires, you can continue to hold the stock through seven months while bringing in an additional profit of $1050 [7 x 150 = 1050]. So, when this covered call strategy is working perfectly, you have increased your profit on this investment from $2000 (67%) to $3050 (102%). While this idealized scenario can happen, it all too often does not.
       The oversimplification in this idealized scenario is that it requires the stock price to move up month-by-month in an almost perfectly coordinated manner in order to achieve the described results. Let's look at a real-life example to see how things might not progress quite so perfectly. The overall price movement of XYZ in the idealized scenario is similar to that of Qualcomm Inc. (QCOM) in 2003, as it moved from $30 in mid-May of $50 in mid-December. Unfortunately, the month-by-month price movement of QCOM was not always coordinated with the options expiration date so as to allow an easy decision about proceeding into the next month.
       Concretely, if you bought 100 shares of QCOM in May for $30 and sold 1 Jun 35 call for $1.0 a share, you were soon confronted with a difficult decision when the stock closed near $37 at the June options expiration - (i) Do you buy back the short option for a loss in order to continue holding the stock or (ii) do you give up on any future gains in the stock by letting it be called away, as you settle for a quick profit of $6.0 per share [35 - 30 + 1 = 6]? Assuming you decided to stay in the stock, you might then have sold 1 Jul 40 call for $2.0 per share. When the July options expiration was reached, the $40 call expired worthless because QCOM had fallen back to $35. You again had a difficult decision to make - (i) Do you sell 1 Aug 40 call for only $.40 per share, while hoping for the stock price to recover or (ii) do you sell 1 Aug 35 call for $2.0 per share in case the stock continues to fall or just goes sideways for the next month?
       While not every month will pose such difficult decisions, you can be sure that such questions will arise if you plan to hold your stock over a long period of time. The message here is that the actual management of covered calls is typically not as straightforward as described by the idealized scenario.
       Now let's get back to the issue of the risk in a covered call trade. To make things definite, we will again use QCOM as an example. In late December 2003, you buy 100 shares of QCOM at $53, and to complete the covered call play, you sell 1 Feb 55 call for $2.0 per share. This means that you have equivalently purchased the stock for $51 per share, and hence your maximum risk on this covered call trade is $5100. If QCOM is above $55 at the February options expiration, then your stock will be called away, which provides you a profit of $4.0 per share [55 - 51 = 4]. On the other hand, if QCOM has fallen to $40 as the option expires you will be able to keep your stock, but the value of your stock will have decreased by $11 per share [51 - 40 = 11].
       Let's compare this "conservative" covered call trade with the "risky" selling of a naked put on QCOM. Instead of buying QCOM stock, suppose that you sell 1 Feb 55 put for $4.0 per share. The risk here is that you will be required to buy 100 shares of QCOM at the equivalent price of $51 per share [55 - 4 = 51], so again your maximum risk is $5100. If QCOM is above $55 at the February options expiration, the short option will expire worthless and the cash brought in from selling the put can then be counted as a $4.0 profit [4 - 0 = 4]. On the other hand, if QCOM has fallen to $40 as the option expires, the put will be exercised, requiring you to buy the stock at $55 per share. This means that you then own a stock in which you have suffered a loss of $11 per share [55 - 4 - 40 = 11]. Thus, we see that no matter what QCOM does, our profit or loss as well as our maximum risk in selling a naked put is the same as the covered call trade.

       They are no more "conservative" than selling naked puts. Their month-by-month management can be tricky.
       So what is the answer about the use of covered calls? Here are some suggestions for the beginning options trader:
       1. Be aware of the risk. Since almost all of your risk is in what you paid for the stock, keep your eyes on the stock price and to a much lesser extent on the option price. Decide on an appropriate stop loss price for the stock, and if it falls to that level, protect the major portion of your investment by selling the stock and buying back the call. You will make some profit on the call to offset part of your loss in the stock.
       2. Judge the strike price. When deciding upon the strike price of the call that you are going to sell, make sure it is a price at which you will feel comfortable about selling your stock if necessary. If your goal is to keep your stock, then select a higher stock price. If you are willing to sell your stock near its current value, then pick a nearby strike price to bring in more cash.
       3. Don't go too far out in time. In selecting the option expiration month, generally use the front month or the next month out. In today's volatile market, a stock can move a lot (up or down) in 4-6 weeks. By selling near month options, you will be better placed to make an adjustment when the expiration date arrives.
       4. Don't be greedy. If the stock price has gone above the strike price at expiration, don't buy back the option for a loss unless you have a very good reason. If you have followed #2, then you should be willing to let the stock go and take your profit. If you buy back the option and the stock subsequently collapses, then you will have compounded a loss on the option with a loss on the stock.
       Editor's Note: Gregory Spear is editor of The Spear Report, 2558 Albany Ave., W., Hartford, CT 06127, 1 year, 50 issues, $297, www.spearreport.com. Spear offers two separate options services; The Options Play of the Week, a product sold by the week; and The Options Professor, a quarterly subscription weekly newsletter with alerts. Both products trade options on Consensus stocks featured in The Spear Report. For a special, introductory price offer to The Options Professor and Bonus Reports, Options Medley for 2004 call 1-800-491-7119.