Is Covered Call Writing for you?

One Basic Strategy

Up your alley?
Is covered call writing up your alley?. dreamsteam.com

Covered call writing is a very popular option strategy and is especially well suited for people who are first learning how options work. Once you gain a fairly good understanding of the basic concepts involving options and understand the risk and rewards associated with owning stocks, that is a good time to consider adopting this strategy.

However, there is more to this simple strategy that is apparent at first glance.

It is important to understand why an investor would want to write covered calls. Thus, you want to know about the philosophy behind this strategy. Next, it is essential to know about the risk, or what can go wrong when you buy stock and sell one call option for each 100 shares owned.

NOTE: The name of the strategy comes from the fact that the stock owner is covered -- if and when he/she is ever on the short call option. In other words, if assigned, the trader already owns the shares and can deliver (sell) them to the person who exercised the option.

Is Covered Call Writing (CCW) for you?

  • CCW is a strategy for the investor who does not believe in trying to time the market. As long as you are willing to have your cash invested in the specific stock (or index), it is a reasonable idea to own the stock and write the calls. However, if you never want to sell the stock and if your intention is to hold for a long time, then this is not a suitable strategy.
  • CCW is for the investor who wants a higher probability of earning a profit with every trade, even when the profit is limited. Clarification: The profit is earned more frequently than the trader who simply buys stock and does not hedge the position by selling a call option.
  • CCW is for the trader who wants to own a less volatile portfolio -- i.e., a portfolio whose value has smaller up/down moves. This strategy provides a small cushion against losing money during market declines -- but it also limits profits when markets rise.
  • CCW is not for the market timer, especially because of the purchase and sale of options, with their wide-bid/ask spreads, always involves some slippage (loss that results from buying options near the ask price and selling near the bid price).

Investors who choose to sell call options against their long stock positions are interested in collecting time decay. This is a basic property of options: When all else remains unchanged, an option loses some value every day. The amount lost is known as Theta (one of the Greeks). Theta represents

  • The reward for sacrificing additional gains when the stock price moves above the strike price.
  • The profit target when stocks trade in a narrow range.
  • A small cushion that reduces the sum lost when markets fall.

CC writers do not buy and sell the option as its price moves up and down. That strategy involves market timing, and it is more efficient for market timers to buy/sell stock rather than options. Market timers should trade stock with stop orders that limit risk.