An Introduction: Clearing the foggy idea around the covered call.
The ‘pitter-patter’ of the raindrops hitting the window sill as I type this sentence can’t even stop me from clearing the dark clouds surrounding the misconception of the covered call stock option strategy.
In my experience as a stock market option investor, and as a true enthusiast and student of stock market investing, the covered call is probably the most underestimated option strategy. Granted, it is probably the most well known stock option strategy – partly because it is often taught in introductory stock option courses to beginner investors.
Unfortunately, it’s true potential is also overlooked, as many beginner investors are quick to dump the simple covered call to get in bed with the sexier stock option strategies that many websites often pump-up. But then, what is really that sexy about a strategy that can be repeatable, scalable, and often profitable (if done right)? Who wants that anyways?
I will keep this thread as an on-going conversation as I provide details of my own covered call experiences, conversations I have with other well-known covered call enthusiasts, and to dispel misconceptions that many beginner investors have with the covered call strategy.
Part 1.0: The most common way to use covered calls (and why it sucks)
You know what? The covered call does suck. There, I said it. The reason being is that the way it is taught sucks, and the target audience who is learning this strategy is left with the sucky-results. Then, they get discouraged, trash-talk the whole covered call strategy, eagerly wanting to forget the experience in hopes of learning more advanced option topics, go through the school of hard knocks of losing more money, and then look to re-learn the basics of option trading, which should have been taught to them, correctly, from the beginning.
The way most beginners are taught to think about the covered call strategy is to think of it in terms of getting monthly rental payments as a real estate landlord – a nice fat cheque paid on every month, on time. While there is a lot of truth in this analogy, as that really is the best way to describe the covered call method in a plain-vanilla, relatable, down-to-earth manner, this explanation leaves a LOT of information out. I can name two exclusions just off the top of my head:
1. A covered call CAPS your gains. Do you remember the reason why you bought your shares in the first place? I’m guessing it’s because you actually LIKE the company. So why would you shoot yourself in the foot by capping the gains, just to make monthly income which could be just a fraction of potential gains that you miss out (and really, should be entitled to) if your stock goes through a high momentum bull run?
2. The covered call SHOULD NOT be your number one choice of protecting your portfolio: I laugh. No, I literally laugh when I read how people use covered calls to “protect” their portfolios. Yes, there are ways to use the covered calls as hedges, but the way most people are taught to sell covered calls (out of the money strikes, at best, at the money strikes) is a pathetic excuse of a hedging tactic.
Let’s just get technical for a second. Whenever you sell a covered call option, you must own at least 100 shares, right? 100 shares = ability to sell 1 call option. For this example, we’ll assume you have 100 shares of a stock that we’ll call, “HelloStockMarket”, just for kicks.
Rule of thumb: the at-the-money front month call option has a delta of 0.50.
You own 100 shares, each share has a delta of 0.01, so owning 100 shares gives you 1.00
Doing the quick math, you’ll notice you leave your stock portfolio exposed 0.50. This is NOT an efficient hedge!
And this, usually, is the best case scenario, as most covered call books teach you to sell out-of-the-money call strikes (so that you can get that time value depreciation).
So, you’re thinking, “Kunal, then, what is the solution?”
Coming in Part 2.0! Stay tuned. By the way, I will try to update this thread twice a week, but because I work a fulltime job, it may be once a week. So maybe bookmark it if you would like.
Also, leave a comment if something is unclear. I’m trying to make this the most awesome covered call thread available online. I love this stuff! Stock option investing is my passion!