Writing Covered Calls

Many financial advisors and more than a dozen websites advocate writing (selling) covered calls as a sound investment strategy. Thousands of subscribers pay millions of dollars to get advice on profitable covered calls to write.

I believe they are wasting their money. Writing covered calls only limits the potential gain you might enjoy.

Let’s take an example. You buy 100 shares of XYZ for $80 and write (sell) an at-the-money two-month call ($80 strike price) for $4.00. If the stock stays flat, you will earn 5% on your money for the period (plus collect a dividend if there is one). If you can do this six times a year (write a two-month call six times), you will earn 30% annually (less commissions); or so goes the promise.

(In the last chapter we showed that selling calls against a one-year option rather than stock results in a hypothetical 300% gain if the stock stays absolutely flat, or ten times the amount you could earn by writing calls against the stock.)

In this covered call-writing example, 30% is the maximum amount you can earn. No matter how high XYZ goes in price, you can never earn more than 30%. The bottom line truth is that you will NEVER earn that 30%. The reason is that no stock price ever stays the same. If the stock goes up by $5 in the first 60 days, you will either lose your stock (through exercise), or more likely, you will buy back the call you wrote, paying $5, and losing $1 on the call (but making $5 on the increase in the price of the stock). So for the first 60 days, you actually made a 5% net gain ($4 net gain on a $80 stock).

Presumably, you then sell another 60-day at-the-money call (now at the $85 strike) and collect perhaps $4.25. Then the stock falls back to $80. In this time period, you gain $4.25 from selling the call but you lose $5 in stock value for a net loss of $.75.

Your gains on the calls you wrote now total $3.25 for a 120-day period (you gained $4.00 in the first 60-day period and lost $.75 in hoped would earn you 30% for the year). At this rate (four months of activity), your annual return will be $9.75, or 12.2% on the original $80 stock. Commissions on six sales of calls over the year will considerably reduce this return — to 10% or so. Not a bad return, but certainly not 30%. And it’s an awful lot of work for a 10% return.

For a full explanation of an option strategy that is designed to outperform writing covered calls, check out Dr. Terry Allen’s Free Report on calendar spreads.