Many people look at covered call writing as a "safe" way to make extra money off their stock holdings. In reality, covered call writing is a short-term trading strategy that requires one to out-think the majority of option traders in the hopes of making a series of small profits, all the while overcoming considerable transaction costs.

By Todd Beaird (TMF Synchronicity)
July 27, 2000

Last week we talked about strategies that are, essentially, betting against your stock. In particular, we reviewed the strategy of selling ("writing") covered calls.

Well, it seems I struck a nerve there, as many erstwhile covered call sellers came out of the woodwork. I'd like to thank all of you who took the time to send your comments, and because of the number of responses, I've decided to cover (pun intended, sorry) this strategy in more detail.

Before I go on, let me make a quick comment. I feel a little uncomfortable discussing options in detail here. As you may know, The Motley Fool is not fond of options. Used improperly, options can destroy years of careful saving and investing in a manner of weeks. Options have layers of complexity beyond simple stocks, and can easily overwhelm an investor. Add in the fact that options are by nature short-term instruments, and you can see why we don't recommend options. Remember that you can be a very successful investor without ever touching options.

That being said, let's take a closer look at the strategy of writing covered calls. As we've mentioned earlier, a call option is the right to buy a stock at a set price on or before a certain date. A "put" option is the right to sell a stock at a set price on or before a certain date. An individual can either buy or sell these rights, and the seller of an option is often called the "writer" of an option.

Let's use a real-life example. AT&T (NYSE: T) closed on July 25 at a price of $34/share. A call option on AT&T with a strike price of $40, expiring in October, has a bid price (the amount you could get if you sold it) of 1 1/16, and an ask price (the amount you need to pay to purchase it) of 1 1/4. Yes, that is a large spread. That's another drawback of options. But I digress.

In a covered call (or CC) strategy, you would purchase AT&T, and then sell the Oct 40 call, pocketing the premium of 1 1/16. The call is "covered" because you own the underlying stock. If AT&T goes over $40 before October, the buyer will exercise the call and buy the stock at $40. You then have to sell your stock at that $40 price, even if it's currently worth $45 or $50 or even $70.

Many people like CCs because they see them, essentially, as a way to generate some extra money from their long-term stock holdings. The thought is "I already own AT&T. I can sell these options for money, and keep my stock. I only lose if the stock goes up, and I will have sold at a profit! Such problems I should have!" New investors are especially susceptible to the siren call (sorry again) of CCs. It looks like free money, doesn't it?

Think again. Imagine the range of returns on your AT&T stock as a bell curve. The right side of that curve represents the potential gains in AT&T, with the far right side representing a potential price increase to $50, $60, maybe even $70 per share. The left side represents potential losses.

By selling a covered call, you are essentially selling a chunk of that right side of the curve, and keeping the entire left side. As I said last week, you are betting that your stock won't go above the strike price.

Now, several people said that they're not really betting against their stock. They suggested "buying back" the call and/or writing a new one if a stock goes up to the strike price. I really disagree with this strategy. First, the call could be much more expensive to buy back. You will also have to deal with that considerable (usually over 5%) spread on options. In essence, you've just a spent a bunch of money to follow your stock up. Then you've turned around and sold off the upside again for a small premium.

People who sell CCs are not "getting some extra money on their stock." They're placing a short-term bet that a stock will stay within a certain price range. The option position is what they really own, the stock is simply collateral for the position.

It may not be impossible to get market-beating returns by selling CCs, but it's very difficult. Selling covered calls is a short-term trading strategy, where you try and out-guess all those very bright options traders in predicting that a stock will trade within a narrow price range. If you guess right, you will get a small gain, but if you guess wrong, you can miss out on a potentially huge gain. And no matter what, you'll still be stuck with your losers even if the premium softens the loss slightly.

Last week, we described how a few big winners can offset many losers. With CCs, you're hoping that a lot of small winners can offset a few big losses. I'd rather follow a strategy that doesn't require me to be "right" almost all the time. Add in the considerable costs (commissions and spreads) involved, as well as the time required, and you can see why I don't like selling covered calls.

Covered calls do have one redeeming feature, in that they reduce the volatility of your returns slightly. However, if I really wanted to reduce the volatility of my portfolio, I would simply move some of my funds to a good bond fund. Quicker, cheaper, easier.

And that's all the time we have for discussing covered calls. (We could easily spend several years on the topic!) Next week we'll return to traditional Workshop issues. I realize that some of you may still disagree with me about covered calls, or may want to learn more about options in spite of our warnings. If so, I highly recommend visiting the Chicago Board Options Exchange website. They have a very good list of books on options there. Also, right here at the Fool we have a discussion board devoted entirely to options. Again, we strongly recommend against using options, but if you're thinking about it, please educate yourself as much as possible and be aware of the risks involved.

See you next week, same Fool time, same Fool channel!