All about Covered Calls
All about Covered Calls
This week let’s talk about monkeys touting covered calls as the new magic pill that beats dividend investing. No, let's not. Instead, let’s look at a few common misconceptions about covered calls and in the process understand them a bit better.
Firstly let me start by saying that I think covered calls are an excellent tool in a traders arsenal. They are a great way for getting started with trading options. But they have plusses and minuses.. (just like everything else. and no.. ignorance is not bliss).
So let’s get to it by looking at a couple of common misconceptions..
1. Selling Covered Calls is better than Dividend Investing - No it is not. Just because on average you make about 3-6% in dividends at best over an year and that you can collect 1% every month selling OTM calls does not make them better. You are paid that extra premium since you give up on the upside potential. Thats all. It’s a different risk profile you are taking on. Not better.
If somebody is selling a course on covered calls or putting out youtube videos touting how great covered calls are; they could be just ignorant on how option pricing works. There are very few real edges in the financial markets. Supply-Demand is one important structural criteria.. and if looked at from that perspective, covered calls actually are at a disadvantage given the abundance of funds and private traders willing to sell OTM calls. That is also evident in the IV slope of OTM calls.
2. Selling Covered calls is pocketing free money you are leaving on the table - since you have long stock in your long-term portfolios anyways. Nope. That is not true either. There is no free money here. By selling covered calls, like i said above you are basically reducing your delta somewhat (by whatever delta call you sell) - and taking on a slightly different risk profile.
In reality, Covered Calls are extremely simple if you think about long stock as "naked long stock" (term coined by yours truly). Now a covered call just reduces your delta from 100 of a standard 100 lot of shares to a 70 or an 80 (if you sold a 30 or a 20 delta call respectively) at the current price level. As price moves around your delta now gets dynamically adjusted and it can go to Zero if the stock ends above the strike price at expiry. So the only question to ask is are you comfortable with that risk profile..
Infact, selling puts to get long stock below where it’s currently trading and once long, selling a call against it to get out of your long stock is a great way to maintain a small long delta in stocks you want to hold long term. But again... it doesn’t come free. You loose the upside potential for a guaranteed return. If you were to do it consistently overtime, you can perhaps expect to receive similar returns as to being just long the underlying with a slightly muted volatility profile.
Here is a quick comparison:
Ref: https://www.ftportfolios.com/retail/blogs/marketcommentary/index.aspx?ID=4679&Print=Y
So bottom line, for a trader if there are stocks you want to hold long term but want to reduce delta somewhat.. or want to get paid while you wait for the market to drop to your intended entry-level, selling covered calls or selling puts to get long stock is a great way of doing that. Don’t let that lull you into holding long stock just because you have a call sold against it... in big bear markets, the premium from the covered call won’t be enough while you lick your losses from the long stock. Similarly, if the markets trend up big time, you will kick yourself for giving up on the upside potential of your long stock if you did not understand the risk profile before you put the trade on.
That’s all there is to covered calls actually. End of story.
Happy Trading!
-gariki