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Trading Options - Covered Call Trap

Filed Under Beginner Options Trading 

Trading Options - Covered Call Trap
At the beginning of this chapter, we said that covered calls can contain an unforeseen risk, and we’re now ready to show how investors unknowingly can take step right into a trap if they believe that all covered call positions are conservative.
 
Because most investors do not realize the downside risk inherent with covered calls, they unknowingly choose their covered call trades based on the volatility of the underlying stock. An investor new to the covered call strategy may hear that covered calls are conservative and, when searching for investment ideas, will end up choosing the call options that have the highest premiums. After all, if all covered calls are conservative, he feels he might as well choose the call option that brings in the highest premium. However, if you choose the call options with the highest premiums, you have automatically chosen the riskiest stocks since it is the higher-volatility (risky) stocks that command higher option premiums. The investor ends up holding onto a highly volatile stock that he otherwise would not be comfortable holding. These call writers are often called “premium seekers” since they seek out the options with the highest premiums and then they buy the stock for the sole reason of writing the calls. This is a high-risk way to use covered calls that can lead to disastrous results.
 
For example, assume that you are comfortable holding stocks in your IRA (Individual Retirement Account) such as Conservative Consolidated Company but not comfortable with highly-volatile stocks such as Gargantuan Growth Company. If you are new to options and decide to write calls, you would find that the premiums for Conservative Consolidated are not nearly as large as they are for Gargantuan Growth. The reason is simply that Gargantuan Growth is far more volatile. And when stocks are more volatile, option traders are willing to pay more for the options so that they don’t have to hold the stock. When you decide on which stock to buy in order to write calls, you may see a one-month, at-the-money call on Conservative Consolidated trading for 50 cents while an at-the-money call on Gargantuan Growth may be $5.
 
When faced with these prices, you may think that it doesn’t make sense to buy 100 shares of Conservative Consolidated and only receive $50 from the sale of the call when you can buy 100 shares of Gargantuan Growth and receive $500. So you decide to buy 100 of Gargantuan Growth and write the call to gain the $500. But look what just happened. You ended up with the stock that you weren’t comfortable holding. It was the high option premiums that lured you into buying the stock. That’s what happens when you let option premiums dictate which stocks to buy. Investors who base their covered call decisions on option prices end up taking far more risk than they intend and end up holding a risky asset that could fall substantially.
 
Example:
Around 1998, I remember one investor who bought 7,000 shares of Egghead Software (EGGS) at $53 during the “dot-com” craze. (To make matters worse, he bought the shares on margin or borrowed funds.) He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. “Wow, that is over 15-fold on your money” he exclaimed. “At that rate, it would take less than two and a half years to turn $1,000 into $1,000,000.”
 
The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I will let you decide if it was worth it.
 
This trader was correct in realizing that the $8 premium was tremendously high. But there was a reason the markets were bidding up the call options so high. They wanted someone else to hold the risky stock. The risk of a covered call is that the stock falls.
 
Notice how it’s possible for two investors to be using covered calls and yet be on nearly opposite ends of the risk spectrum. Options are risky only if used improperly. Don’t be misled into thinking that all covered call positions are conservative no matter how convincing the argument may sound. If any broker tells you that the risk of a covered call is that you miss out on upside gains then ask him why the strategy is called “covered.” He will immediately tell that it’s because you’re not at risk if the stock rises since you already own the stock. That’s the correct answer but it presents a dilemma since he also believes that you’re at risk if it does rise. The reason that people make this mistake is because they are confusing “risk” with “missed opportunity.” Once again, risk is never defined as missing out on some reward (missed opportunity). People who forget the simple risk-and-reward relationship are easily led to believe that the risk of a covered call is that they miss out on the upside gains and are inevitably led to writing calls on the riskiest stocks they can find. If the “risk” is that you may miss out on some upside gains, you might as well collect the biggest premium you can! These investors usually learn the hard way that there is a big difference between risk and missed opportunity.
 
The very best tip we can give you for writing calls in a conservative way is to be sure you’re buying stock that you wouldn’t mind holding anyway even if options were not available. That way, it shows you’re willing to assume the downside risk and the sale of the call does not change the risk. It simply provides a downside hedge. Don’t let the tail wag the dog by purchasing stocks based on the prices of the options. Of course, it doesn’t mean that it’s wrong to write covered calls because of the high premiums; it just means that it changes the nature of the strategy from conservative to speculative. The point to remember is that all covered calls are not equal. Just because you’ve written a covered call does not make it a conservative strategy. It is your reason for doing it that dictates the risk in the strategy.
 
 
Synthetic Positions
We can use put-call parity to show us added insights into any strategy so let’s see what it has to say about the covered call strategy. Let’s start with the basic equation found in Chapter Five (Formula 5-15):
 
S + P – C = 0
 
Now let’s solve it for a covered call. We know that a covered call is the combination of long stock plus a short call, so we need to get those two assets on one side of the equation. We can see that they are already on the left side, so let’s just move the long put to the right side and change its sign in the process:
 
S – C = -P
 
This equation tells us that the combination of long stock and a short call (left side) is equal to a short put (right side). Any broker will tell you that short puts are one of the riskiest strategies available. Brokerage firms will require your account to have the highest option approval rating along with significant equity before they will allow you to write naked puts. At the same time, they will tell you that the covered call is conservative in nature. Both statements cannot be correct. It depends on how they are used. If you want to use them in conservative ways, make sure you are buying stock you don’t mind holding.
 
Another way to verify if a particular covered call is suitable for you is to ask yourself if you would be comfortable selling naked puts at that time. If the answer is no, then you should not be using a covered call because it is exactly the same thing packaged a little differently.

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