Myths and Misconceptions About Covered Call Writing

10/06/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman of TheBlueCollarInvestor.com addresses five infuriatingly common myths and misconceptions about covered call writing and why he feels option traders would do best to remember that just because they hear something over and over again does not make it fact.

There are certain fallacies and deceptions associated with covered call writing as there are with all investment strategies. I am the first to say that there is no one strategy right for every single investor. We must master the pros and cons of each strategy to determine if it is right for our families. This includes rejecting information that is inaccurate and misleading. In this article, I will address and clarify the reality of the five most common of the covered call writing myths.
 
Myth 1: Sell Options That Generate the Highest Returns

Please do not fall for this one. This would be the tag line for a late-night TV infomercial. At 2:00AM we see John (in black and white with a scowl on his face) working eighty hours a week and still not earning enough money to support his family. Then he starts selling high-premium covered calls and subsequently shown with a smile and in color working five hours a week. By 2:15AM he is at the side of his Olympic-style swimming pool adjacent to his multi-million dollar mansion sipping on a pina colada. All you have to do is sell those 100% annualized return call options. The truth is that high-premium options are associated with high risk underlying securities. Option sellers are getting paid more to undertake more risk. Most of us selling covered calls are conservative investors with capital preservation a top priority and therefore should avoid these options, not embrace them.

Myth 2: Covered Call Writing Underperforms

If you don’t know what you’re doing, any strategy will underperform. From a more positive vantage point, we can succeed at most conservative strategies if all aspects are mastered. Covered call writing is considered by many the most conservative option strategy. There are three required skills needed to succeed and outperform: selection of the underlying security, selection of the most appropriate option, and position management. If all three of these skills are mastered, we should outperform all normal market benchmarks.

Myth 3: Assignment of Our Shares Is an Unacceptable Likely Outcome

I’m getting angry just typing these words. If there are tax issues there are ways of circumventing assignment. Let’s assume no tax issues for this segment. Those using this strategy have clearly defined goals: income generation, limited downside protection by the option premium, and willingness to sell the shares at the strike price. All these goals can easily be met whether shares are assigned or not. This relates to our three required skills including position management. Share assignment can be avoided more than 99% of the time if that becomes one of our goals. The truth of the matter is that we are generally concerned about the cash invested in a stock, not the stock itself when using traditional covered call writing (as opposed to portfolio overwriting). Furthermore, if you subscribe to the BCI rule that we never sell an option if there is an upcoming earnings report, we are never in a particular stock position for more than two months in a row. This is why we highlight stocks with upcoming earnings reports in our Premium Watch Lists.

NEXT PAGE: A Myth Repeated Is Still a Myth

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Myth 4: We Are Forced to Sell Winners and Hold on to Losers

Now I’m really boiling. Let me go throw some cold water on my face…okay, I’m back. No one forces us to do anything. We are (almost) completely in charge, unexpected early assignment being the rare exception. Even if early assignment does occur, we can always buy back the stock if it is in our best interest. We can hold on to winners if the strike is in-the-money by rolling the option. We can and should sell a loser, especially one underperforming the overall market. One of the advantages of covered call writing is the incredible amount of control we have in the outcome of our investments. Those who allow this myth to become a reality will also subscribe to Myth 2.

Myth 5: We Should Use Covered Call Writing Because 90% of All Options Expire Worthless

This claim misstates a statistic published by the Chicago Board Options Exchange (CBOE), which is that only 10% of option contracts are exercised. But just because only 10% are exercised does not mean the other 90% expire worthless. Instead, according to the CBOE, between 55% and 60% of options contracts are closed out prior to expiration. In other words, a seller who sold-to-open a contract will, on average, buy-to-close it 55-60% of the time, rather than holding the contract through expiration.

So if 10% of options contracts end up being exercised, and 55-60% get closed out before expiration, that leaves only 30-35% of contracts that actually expire worthless as shown in the figure:

chart
Click to Enlarge

The big question is: of the 55-60% that get closed out before expiration, how often did the option seller profit and how often did the option buyer profit?

Much of the answer would depend on the movement of the underlying stock(s). In a simplified example, pick any of the Dow components and suppose that from this day forward through expiration, the stock flatlined, neither moving up nor down. Any options out-of-the-money would end up expiring worthless, and therefore, the sellers of those options (both on the puts side and the calls side) would be the ones cheering their profits. Now suppose instead that we look at all of today’s out-of-the-money options in the scenario where tomorrow the stock jumps substantially and stays at those high levels until expiration. In that scenario, the puts that had been out-of-the-money (and even some that had been in-the-money) would expire worthless, but a lot of the calls that had been out-of-the-money would now be in-the-money and the call buyers (not the sellers) would be cheering their profits. As a third scenario, suppose we look at all of today’s out-of-the-money options if the stock were to fall tomorrow on some catastrophic news. In that scenario, the calls that had been out-of-the-money (and even some that had been in-the-money) would expire worthless, but a lot of the puts that had been out-of-the-money would now be in-the-money and the put buyers (not the sellers) would be cheering their profits.

There are many reasons to consider using covered call writing but buying into the myth that 90% of options expire worthless should not be one of them.

Discussion

Just because we hear something over and over again does not make it fact. Politicians use this ploy all the time. As Blue Collar Investors, it is our responsibility to discern fact from fiction.

By Alan Ellman of TheBlueCollarInvestor.com

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