By Doug Tucker
While there is much interest in trading equity and index options, it is also a well-known fact that the vast majority of these options expire worthless. By most estimates roughly 80% of these options expire worthless. With odds like that it is no wonder that thinking of being a seller of options is so enticing. But do they really give money away that easily on Wall Street, or in the case of most options, on LaSalle Street? What about the other 20% that don't expire worthless? With a big chance of success but small profit objective, or a small chance of loss with essentially unlimited loss potential, the problem becomes evident. The risk reward on an outright option sale, or short option position, has an out of balance risk vs. reward ratio.
However, the lure of capturing the option premium with a high probability of success is still intriguing. Add to this the fact than an option is a naturally wasting asset. The possibilities seem well worth investigating. If only there was a way to hedge that small chance of the market causing serious damage to your trading account, or worse, wiping you out.
There are many spreading techniques to help avoid a catastrophic loss on a short option position, such as having an offsetting long option position that would limit the loss. These strategies can get quite complex and costly to implement. But one strategy has been highly touted over the years as being a safe and sensible way to capture this option premium with minimal risk. It is often promoted as a way to enhance overall return, or to provide income from stocks already being held. And that strategy is to sell a call short against a long position actually being held in the underlying asset. In other words, a covered call, where the risk to the short call position is actually being covered by being long the stock.
This strategy sounds like a real winner in theory, and at times can produce the desired results. But the brokerage and advisory businesses are not very good at disclosing the obvious pitfalls to this strategy than can blindside an approach that was supposed to be safe and conservative.
First, the ideal covered option writing strategy would be in a stock where you could define a probable range where it is likely to trade and have that range not exceeded, therefore not endangering your long position from being called away. And, it would also be preferable for the stock to be volatile enough to create a sufficient premium to make the transaction worthwhile. These two conditions are usually not present at the same time.
When a stock is trading sideways and volatility is low, the option premium is usually too low to warrant selling. If you owned a $50 stock, why would you want to limit the upside potential if the only option you could sell would be for 50 cents? That might be all you could get on a sideways, range bound stock. But volatility is cyclical and if the stock breaks out of its range and moves to $60, you'd be forced out at the strike price of $50. But worse, if the stock breaks to the downside and goes to $40, the 50 cents you received for the call option sale is not much of a cushion. As a result you are stuck with a losing long position. If you still want to hold the stock at a loss, any additional calls you might write at the new lower price would probably insure a loss on the stock if called away, and it would likely be a loss larger than the premiums you took in.
On the other side of the coin is the option that has a very volatile underlying stock. Take another stock at $50, but this time there is an option trading at $5. That's a 10% premium (leaving out any intrinsic value for sake example) and it seems very worthwhile to capture this excessive premium. Obviously there are many option buyers who think the stock will surpass $55 before expiration or they would not be putting on the trade. You reason you can buy the stock at $50, sell the option at $5, and have downside protection to $45. Of course you will capture that entire $5 premium at expiration no matter what happens to the underlying stock. If the stock stays at $50 you would have the best situation, as you will be most likely be able to write another call and repeat the process. But if the stock is volatile enough to cause such a high premium the odds are not high of that happening. What if the stock goes to $60 or $70? Do you exit the whole trade before expiration? Has the option premium decayed so you still have some profit, or has the volatility increased so you have to buy back the short option at even more of a loss than the intrinsic value. Do you wait until expiration and tie up your money in a boxed in trade where there is little to be gained? Do you take a loss on the short call option, hold onto the stock, and hope the stock keeps going higher? And where do you put a stop on the underlying stock if it starts to decline, especially below your breakeven point?
Sometimes the greatest option premium occurs after a stock has topped out and had its first correction, and tries repeatedly to re-test the highs, thus increasing volatility. Many traders who missed the move will be tempted to buy on the correction, thinking another leg is in the works. This can create much volatility and expand the option premiums temporarily. A high volatility, but sideways channel can seem to be forming. This can seem ideal for a covered call writing campaign. It can be lucrative to sell these options, but keep in mind that the stock has a good chance of giving up the battle and selling off sharply very quickly, especially if the preceding run has been a long one. These high volatility channels are often topping formations and do not last. Many gains from selling the options repeatedly can be wiped out by one sharp and fast down move in the stock. It isn't easy psychologically to exit the long position in the underlying stock when you've been in a successful option selling campaign and all the analysts are still talking the stock up. Once the stock is out of favor, with the perception that the move it enjoyed is now yesterday's news, the option premiums tend to deflate. You are then left with a stock showing a loss, with only lower priced options available to write, and if done will surely lock in a loss if called away at the lower strike prices.
To be successful at covered call writing in the long run, and to outperform an index benchmark, one has to have nearly perfect timing skills and excellent discipline. If one possesses great timing skills and discipline, it would probably be far more lucrative to just trade the stock or index outright as a net long or short position. Also, for short-term trades that are not exposed to excessive option premium decay, trading the options from the long side would at least have the risk vs. reward ratio favorable. It is easy to design a trading system or approach that will produce a very high percentage of winning trades if the winning trades are very small, while leaving the smaller percentage of losing trades very large.
The nature of option selling assures this situation. Engaging in the activity of selling these options on a basket of stocks will insure, in the long run, that the good stocks will be culled away, thus leaving a portfolio of poor performing stocks. This is exactly the opposite of what a good trading or investing plan should be.
Doug Tucker has a blog with daily commentary on stock indexes, precious metals, and other markets. There are many articles on technical analysis and indicator design and interpretation. To visit go to: http://tuckerreport.com/
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