Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!

Covered Call: Conservative, Risky, or Both?

So far in this series of articles we haven't discussed actual trades. Most of the discussion has been about the fundamentals and theory of options trading. Things that I think are vital to what we're trying to do; make consistent profits with minimal risk. Truth is there's a lot more we have to cover before getting into the actual trading. However, there is one subject that comes up so often and seems to cause so much confusion, that I think it needs to be covered now. So what do you call what I'm going to cover? You guessed it, the Covered Call.

Definition: A "Covered Call" (affectionately referred to as a CC) is a position consisting of long stock and the equivalent number of short Call options. For example, being long 1,500 shares of XYZ stock and being short 15 XYZ June 50 Calls, is a CC. The stock is covering the obligation of the short Calls.

If the stock is being bought at the same time that you are writing the Calls, the strategy is generally called a "Buy-write." If you already own the stock and then write the calls, it's generally referred to as an "Overwrite." These may be the official terms, and I'm all for precision, but in practice most brokers and many traders just use the term "Covered Call" in all cases.

If you're not familiar with this type of position, you're probably wondering why and when do I put on a CC. One reason might be to bring in some income. Another might be to reduce the risk of stock ownership. Think about what could happen. If the stock goes down in value, the sale of the Call will give you some protection. On the other hand, what are we giving up; we've previously learned that there is no such thing as a free lunch. We're giving up the upside potential of the stock. When the Call option expires, if the stock price is greater than the strike price, we will be assigned on the short Calls and our stock will be called away. In this case the most we can make is the sum of the appreciation on the stock and the premium we took in for selling the Calls.

Let's take a look and see what happens at expiration if we put on the following position:

Buy 1000 shares of XYZ stock at 51, and simultaneously
Sell 10 May 55 Calls @ $3.

XYZ	G a i n / L o s s
	Stock	Calls	Total
44	-7,000	+3,000	-4,000
46	-5,000	+3,000	-2,000
48	-3,000	+3,000	0
50	-1,000	+3,000	+2,000
51	0	+3,000	+3,000
53	+2,000	+3,000	+5,000
55	+4,000	+3,000	+7,000
56	+5,000	+2,000	+7,000
57	+6,000	+1,000	+7,000
58	+7,000	0	+7,000
60	+9,000	-2,000	+7,000

It looks like the maximum we can make with this position is $7,000. It doesn't matter how high the stock goes, the maximum profit is $7,000. If the stock didn't move at all, and just stayed at $51, we would keep the $3,000 and that would be our profit. Finally if the stock goes down in value, the loss could be unlimited (down to 0), but is reduced by the $3,000 we took in by selling the Calls.

Based on these results, it seems obvious that we would want to have this kind of position when our outlook is neutral to mildly bullish. Obviously if our outlook is bearish we wouldn't want to have a CC position, and also if we were very bullish on the stock, why limit the upside by selling the Calls. In a later article, I'm going to show you how to add the graphs together for stock and short Calls, but for now, what kind of position has the same characteristics as the CC, limited upside potential and unlimited downside risk? If you said, or at least thought to yourself, a Put, then this options stuff is making sense to you.

Instead of doing the CC in the example above, we could have just sold the May 55 Put, which would have been trading for about 7, based on Put/Call parity (assuming 0% interest). If you add another column to the table above for the gain/loss on this Put, you'll see that the numbers will be the same as the Total column. That's pretty amazing. Furthermore, selling the Put has at least 3 advantages over the CC:

1. Commissions are reduced, since instead of stock and Calls, we're only trading Puts.

2. We only have to deal with one bid/ask spread, instead of 2.

3. The margin requirement on the short Put is less than on the CC.

The equivalency of these 2 positions, the CC and the short Put is just one of 6 very important similar relationships. These relationships are referred to as Synthetic Positions and we could say that a short Put is synthetically equivalent to long stock and short call. We will examine all of these positions and their Greeks in a later article.

There's an interesting lesson about perception here. It is generally thought that the CC is a relatively conservative position. This view is reinforced by many brokers, since if they allow you to trade options at all; they will approve you to trade CC's.

On the other hand, short Puts are considered very speculative and risky, and most brokers require that you have the highest level of option trading approval before you can trade them. So what's going on, how can 2 positions that are basically equivalent be thought of so differently? My feeling is that the truth is somewhere in the middle. Covered Calls are more risky than generally perceived and short Puts are somewhat less risky. Let me know what you think.

An additional thought regarding brokers comes to mind. The option approval levels were put in place to protect both you and your broker. With a CC position, you are taking a risk that the stock can go down in value, but what risk is the broker taking? None, you own the stock so the broker has no risk on the downside and on the upside if your Call is assigned, you lose your stock, but the broker is whole. On the other hand, with the short Put, if the stock should fall precipitously and you can't cover the loss, the broker would have to make it good. Bottom line is that it certainly appears that the option approval levels were put in to protect the brokers as much as to protect the public traders.

There's actually a lot more to CC's than I've covered so far. Some questions you might have are:

What stock should I pick?
What strike should I write, ITM, ATM, or OTM?
Which expiration date should I choose?
What rate of return will I earn?

These questions and more will be addressed at a later date. So keep on reading and learning!

As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

11. Know Thy Options!

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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