Covered Calls

Yesterday I told you a little about naked puts and calls — games you always win (until you go broke). But what of writing “covered calls,” where you own the underlying stock against which you sell the calls?

Covered calls are perceived to be much less dangerous than naked calls (where you don’t own the underlying stock) — and they are. At least you can’t lose everything. Normally, they are a way to enhance your return. Here was a stock paying a 3% dividend and appreciating maybe 6% a year. You decide to write calls against it every couple of months, pocketing a couple of hundred bucks each time that might add another 15% a year to your return. Ain’t hay!

The calls you choose to write, in this example, are always at a strike price high enough above the current market price that they’re not likely to be exercised. And even if they were — well, what would be so awful about that? You bought the stock years ago at 40, say. Now it’s 60. You agree to sell it at 65 any time in the next couple of months — and are paid a couple of hundred bucks for making that agreement (writing the call). Now the stock jumps to 80. Well, you get your $65 for a stock that was 60 when you wrote the call, and you get to keep the couple hundred bucks. The only “downside,” if you can call it that, is that your profit is less than it otherwise would have been — you get $65 instead of $80 — and you’re forced to “realize” and pay tax on the gain.

(Actually, there are ways to avoid that. You can either buy back the call before it’s exercised or, if you miss that chance, buy new shares at $80 and deliver them at $65, rather than deliver the shares you bought years ago at 40.)

So why isn’t this one a money machine? It usually is. But not only do you limit your “upside” — at 65, in the example above — you retain the full “downside.” What if the market tanks, or just this stock, and it drops from 60 to 14?

So even covered calls, in the long-run — though not remotely the gamble naked puts or calls are — are a true money machine for one party only: your broker.

Tomorrow: A Cure for the Common Cold