Understanding the Covered Call Trade

Are Covered Calls for You?

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Question from a reader:

"What I don't get is this: Once I've sold my covered call and have that position, when the stock price starts moving higher, the option price also starts moving up. That is reflected as a loss for my portfolio that day, and my balance has decreased by whatever amount the option price has increased -- and will continue to do so until the price of the option turns around -- and that usually means the stock price is going down (or the expiry date is getting near).

In fact when the stock price is declining that is when I see the opposite effect: The option price becomes low, compared to when I sold. That means that I get a little money added to my daily balance.

"Why does this happen? Why do I lose money when the stock price rises?"

My reply:
When you own a covered call position, do not think of the position as consisting of two separate parts. Think of it as a single, hedged (reduced risk) position. When the stock price rises, you make money. This occurs because you own the stock, and stock increases more than the option as the stock moves higher. Why? Because the stock has a 100 Delta and the call option has a lower delta. From your question, I assume that you are a novice option user and that you have not yet paid any attention to the Greeks. It is worth your while to read a bit about the Greeks, but there is not yet any need to spend a lot of time understanding the details.

But the basic concepts are useful to a trader at your level of experience. 

As the stock moves higher, so does the price of the call option. That is how a hedge works: The gain (or loss) from one part of your position is PARTIALLY OFFSET by a gain (or loss) on the other part of the position.

When you decide to hedge a position, you are accepting a trade-off in which your newly hedged position loses less money when the market does not go the way you want.

But it also reduces gains when the market moves your way. Look at it this way: You owned a long position (long stock). That position was not hedged. Then you sold a call option, which is a short position because it loses money when the stock price rises and gains when the stock falls. The combined position is called a covered call and all gains from the long position (stock) are partially offset by losses from the option. Thus, you may lose money on the call option when the stock rallies, but overall, the whole covered call position makes money.

If you do not like the concept of making less money when stocks rally; if collecting the option premium is not a sufficient reward to make you comfortable reducing possible upside profits; then covered call writing is not for you.

To hedge or not to hedge
When investing for the longer term, you must have some idea of what you want to accomplish. If you expect stock prices to rise decade after decade, if you believe that you can earn more money by continuing to own stocks for a long time; if you prefer to seek big rewards -- but with the risk of losing more money when markets fall -- then you do not want to hedge your trades.

If you don't know whether stocks will move higher or lower (If you are honest with yourself, you know in your heart that predicting the stock market is a next-to-impossible task for the vast majority of traders), then you should prefer to hedge your bets.

By writing covered calls (or by adopting other risk-reducing option strategies), you know that you will always earn more money than those who do not hedge whenever the stock market falls or holds steady. You will also outperform when the market makes small gains. The only time that the unhedged trader does better occurs when markets surge. If you are willing to outperform the market most of the time and can sit and watch while markets surge and others are boasting of larger profits than you are earning, then hedging is for you.

Buying back the calls on rallies is not a good idea for investors who adopt the covered call writing strategy. That is just an inefficient way to attempt to time the markets.