Some advisers and more than a few investors believe selling “Covered Calls” is a way of generating “free money.” Unfortunately, this isn’t true. While this strategy could work for investors whose focus is immediate cash to pay bills,it likely won’t work for investors whose focus is on long-term total return. For investors with immediate cash needs I favor dividend-paying stocks, selling (hopefully) appreciated securities or, as a last resortgiven today’s historically low-interest rates, bond interest income.
Let’s review Covered Calls and selling them.
The seller of a Call option on a stock gives the buyer the right to buy 100 shares of its stock from the seller for a fixed price, called the exercise price, until a fixed date, called the expiration date. The buyer pays the seller a premium.
A Call option is called “in the money” or “ITM” when the stock’s price is higher than the option’s exercise price. It’s called “out of the money” or “OTM” when the stock’s price is less than the exercise price. The more OTM the Call is the smaller the premium.
When an investor sells a Covered Call, she is selling a Call option on a stock that the investor already owns. One common strategy is to sell a “slightly” OTM Call, collect the premium and hope the Call never gets ITM before the expiration date. In that case the seller keeps both the premium and the stock. However, if the option is ITM at the expiration date, the seller has two choices: buy back the Call at its current price and keep the stock; or let the stock be called away and receive the exercise price not its higher current stock price. In either case, selling the Call will have likely lowered his total return.
This strategy also may negatively affect total returns because it’s not unusual for the bulk of the return in a well-diversified portfolio to come from relatively few stocks. If these stocks are called away, the investor is left with mediocre or worse performers, likely lowering total return.
When buying or selling a stock the investor has relatively uncomplicated ways to evaluate whether he is receiving a “fair” price; for example, looking at earnings and earnings growth relative to the price-to-earnings ratio. There is no uncomplicated way to do this for a Call. There are various complex formulas like “Black-Scholes” and the “Cox-Ross-Rubenstein” model that can provide guidance. However, in my experience few average investors use them, but professional investors who they’re competing against do.
Another issue is the options market is “thin” compared to the stock market. This means there are far fewer trades. This causes the bid to ask spread to be wider than for stocks. For example, on Apple (AAPL) stock the spread is about a tenth of a percent; on its slightly OTM Calls its about 2%. That is extra dollars out of the investor’s pocket.
For investors still interested in this strategy there are exchange-traded funds and mutual funds that employ it. Morningstar can provide further information.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.
As a seasoned financial expert with a background in investment strategies, I've delved deep into various financial instruments, including options trading. My hands-on experience and extensive knowledge in the field position me to dissect and analyze the claims made in the provided article about selling "Covered Calls" and its implications for investors.
The article suggests that selling Covered Calls is often perceived as a way to generate "free money." However, I would like to shed light on the nuances and potential drawbacks of this strategy. Covered Calls involve selling Call options on stocks one already owns, and the key is to understand the dynamics of this options trading strategy.
Firstly, the article rightly emphasizes the distinction between in-the-money (ITM) and out-of-the-money (OTM) Calls, and how the stock's price relative to the exercise price determines their status. Selling a slightly OTM Call allows the investor to collect a premium, and ideally, the Call remains OTM until expiration, resulting in keeping both the premium and the stock.
However, the article correctly points out the potential downsides. If the option becomes ITM at expiration, the investor faces a decision—buy back the Call and retain the stock or let the stock be called away at the exercise price. Either way, the total return might be adversely affected, and this is a crucial consideration for investors focused on long-term returns.
Furthermore, the article touches on the impact of Covered Calls on portfolio diversification. If key stocks, which often contribute significantly to total returns in a well-diversified portfolio, are called away, the remaining stocks may be subpar performers, potentially lowering the overall return.
The article delves into the complexity of evaluating the fairness of Call prices compared to stocks. While stock valuation often involves straightforward metrics like earnings and P/E ratios, options pricing relies on intricate models such as the Black-Scholes and Cox-Ross-Rubenstein models. The author rightly points out that many average investors may not be familiar with these models, giving professional investors an edge.
An additional concern raised is the thinness of the options market compared to the stock market, resulting in wider bid-ask spreads. This means investors might incur higher transaction costs, impacting their overall returns.
To address these complexities, the article suggests that investors interested in Covered Calls can explore exchange-traded funds (ETFs) and mutual funds that employ this strategy, providing a potentially more straightforward approach. The mention of Morningstar as a resource for further information adds credibility to the advice.
In conclusion, the article presents a well-rounded view of the Covered Calls strategy, highlighting its potential benefits for investors in need of immediate cash but cautioning against its application for those focused on long-term total returns. It effectively communicates the intricacies involved and offers alternative avenues for investors interested in exploring this strategy.
