High Risk Covered Calls or Low Risk Covered Call Options

Are you an option trader ? Do you sell covered calls?

Today I just wanted to discuss how you can influence your levels of risk by several key factors when and if you sell covered calls.

For brevity, I am going to assume that you all know how to ¨sell to open¨ covered calls. If you do not know what  a covered call option is.....then this post may not be helpful.

What raises risk in a covered call scenario?

permit me to draft a list:

• Selling covered call options way out into the future...such as 6 months or even 2 years into the future. The future is unknown and the more we try to predict long term results....the more risk we may encounter....due to unexpected market movements.
• Using leverage to finance the purchase of the underlying asset. Using margin debt to finance your purchases of the underlying asset adds more risk to your portfolio. Not only must you prepare for interest payments on the money you borrow in your margin account, but you must prepare to prevent a margin call on your account, when/if your buying power becomes challenged by negative market forces or poor investing choices.
• Selling covered calls on equities that have an unproven financial record can/may add more risk to your accounts. When investors choose to sell covered calls on publicly traded companies that have no positive financial reports, they add unintended risk to their holdings.

There are several ways to minimize risk when selling covered calls on your stock portfolio. 

Permit me to draft another list:

• Sell covered calls on stock that you have paid for in full....(without leverage)
• Sell covered calls on companies with proven sound financial management, that produce healthy price to earning ratios(p/e ratio) and have a good reputation. Have a healthy respect for positive earnings. What is trendy is not always a ¨good bet¨.
• When you want to withdraw money from the premiums you have collected by selling covered calls, only do so after the contract has expired or been closed or assigned. This simple tactic will prevent unnecessary stress if/when a covered call position runs in a direction that you did not expect.
• Last but not least...do not lower the strike below your cost. This is very important, so that you do not risk losing money on the difference between your net cost of stock and the potential inflow of cash if/when a covered call that you have sold gets ¨assigned¨. To be fair, it is important to note, that there may not always be a strike price available at the correct price point to make your trade profitable. Therefore you may have to just ẅait and hold onto stock that needs time to recover from a market dip. This is another reason why it is prudent to eliminate the use of debt/margin/leverage when purchasing equities....so that you will be able to weather market ups and downs..... while maintaining a stress free and dignified investing experience.

Well.... that is all friends, for today. If you are an option trader or investor, I am sure you have discovered a plethora of methods you can use to control and/or define your risk. There is nothing more important in investing than controlling risk.

May God bless your trading and investing as well as your learning journey.

Peace,

Carla.

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Beware of Evidence Based on False Investment Assumptions

I have seen/read several "experts" or "pros" who quote
stats supporting the widespread use of  selling covered calls as a source of regular income who
keep quoting stats in a way that grinds me wrong.

When it comes to the stock market, pretty  much NOTHING is guaranteed.  Risk is something that can be "managed" but usually not entirely protected  against.

If you have an interest in options trading you may find this post  compelling.......if not you may want to skip ahead to another post.... Just sayin' ")

So, I just wanted to mention that when you look at a quote of a covered call premium that would potentially be paid to you if you sold a covered call at precisely that moment and had your bid honored and accepted and the order filled by your broker.... let's  call that "Premium X"

So....what I see happening is that "experts" who are hyping the advantages of selling covered calls for generating income are taking a brief premium quote and then blindly multiplying that to cover one year span of time, based on the FALSE assumption that this same scenario will exist identically on  a weekly or monthly basis ALL YEAR LONG. Then they face you with a toothpaste smile and say "See how high of a return you can earn just be repeating that pattern for one full year?" They try to entice you by showing you how, based on that one brief quote of "PremiumX" how you can double your money in 18-24months. But I want to ask you. Is that a fair assumption? Can you really take a random call option quote and multiply that by how many trading weeks/months are in the year and use that as a baseline income assumption?

Those kind of false assumptions do not take into account any kind of risk or volatility!!!

If you actually fall for that line of reasoning you are setting yourself up for huge potential losses.
Taking one random quote CAN NOT and SHOULD NOT be used a fair gauge of income generation from a covered call writing strategy. Covered Call writing can and may indeed bring in to your accounts a legitimate cash flow. But it depends on a multitude of very crucial factors.

Permit me to express some of these crucial factors:
1/ what is the current market climate for the underlying equity that you are attempting to write the covered call on ? Does that equity have an "up" season and a "down" season?
2/ Is there a consistent demand for options on that equity, or is the demand hard to predict?
3/ Companies sometimes go through extended years of negative  returns, which harshly impact any kind of positive uptrend in share pricing. How will your covered call writing be affected by a tanking stock price that  lasts more than a year?
4/ If the market for options dries up for a certain equity, are you willing to pivot and change your income strategy? Do you have enough funds to re-position and try options trading again, but with a new position on a different equity?
5/ Do you have an exit strategy if/when a trade takes an unexpected turn?
6/ What is the P/E ratio for the equity that you are writing covered calls on?
7/ Do you really understand the risks of trading options on really volatile equities with "unknown" fundamentals?
8/ Do you have other sources of income if/when you make an error of judgement? Even seasoned traders occasionally make a clerical error that can cause a loss in income. Seasoned traders know too well when their emotions have gotten the best of them and they know when it is time to walk away from trading for the rest of the day and start again on a new day.
9/ Do you have the wisdom to manage your positions on a regular basis? Selling options for consistent income requires managing your positions. One should not just "set it and forget it" if you want to protect your investments.

Markets ebb and flow. Prices of equities flow up and down and sideways. Sometimes they go bust.
Sometimes options prices are so volatile that even regular traders have a hard time following their movement and timing their trades in a consistently profitable pattern.

That  is why, it is not prudent or logical to  say that writing covered calls is Always a great idea based on the numbers gleaned from one random option premium plucked from one potential trade on one possible trading day.

There are a million different things that can affect your ability to get the price you want to collect for a covered call premium. There are also a million different  things that can happen to the underlying equity that you are writing your covered call on.

In some parts of life, blind optimism can be a great asset. Not so with financial matters. It always pays to be prepared for every possible scenario that can unfold in the markets and to be able to be flexible enough to adjust your strategy to take advantage of up markets, down markets, and sideways markets.

When something, especially in the financial world sounds too good to be true.....it just may be too good to be true. Don't just question the statistics that "experts" quote. Question how and when the statistics were collected. You can't just measure potential options trades based on one random happy sunny trading day. One also needs to prepare for those days when the clouds roll in and the profits are harder to find.

 Just take a closer look at what happened to most equity prices in the 2008 recession.  Big dips happen. Prices can take as many as 4 years or more to bounce back from a big dip. I am not trying to depress you. I am simply trying to suggest that we all need to prepare for the rainy seasons as well as for the days filled with sunshine.

In peaceful productivity,
.
C.


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