Writing covered calls as a feasible source of income for retail investor?

October 2, 2009 12:39 PM

Writing covered calls as a feasible source of income for retail investor?

I've been reading up on options trading, and from my understanding covered calls is a low risk way to generate some profits on your stock.

Is it possible and feasible for a retail investor to make regular income from covered calls? I'm not looking for huge gains, just extra $500 or so there and there.

If yes, then what kind of stock should I be writing covered calls on?

posted by pakoothefakoo to work & money (8 comments total)

Honestly, I'd skip this plan if I were you--no offense, but you may be a little out of your depth if you're asking AskMe for advice on this strategy. Do you understand how the Black Scholes option pricing model works? It sounds like you're talking about buying stock to make the premium on. Premiums are high on high-volatility stocks (other inputs in the option pricing model being constant). However, the volatility that makes the option valuable is just as likely to burn you on the downside unless you're buying puts. What about your trading costs? The investment banks have this covered, and I really doubt you'd ever many any money on this and you could lose a bunch.
posted by Admiral Haddock at 12:57 PM on October 2

Definitely seconding Admiral Haddock. There's no such thing as a free lunch, especially in this market.
posted by dacoit at 1:08 PM on October 2

Alright, thanks for your frankness, yep I'm out of my depth.
posted by pakoothefakoo at 1:52 PM on October 2

You will get eaten alive by paying retail fees, this is only really economical for professionals and institutions. There is also an inherent risk to covered calls, this isn't arbitrage. Retail investors get killed by fees and avoiding strategies that produce fees should be a priority.
posted by geoff. at 1:54 PM on October 2

I'm not looking for huge gains

But the occasional rips are how you make money. Smart investing means cutting your losses early and often, and letting the winners run. You can make up for several 10% losses with just one position of equal value that doubles. Writing calls means signing away your right to those rare bursts.

A better strategy might be to sell some stock after huge news- or event-driven gains. You can buy back in later either at some lower price, or even as it continues to rise using dollar cost averaging.
posted by fatllama at 2:19 PM on October 2

Yeah, I make several hundred to a few thousand a year on covered calls as a nonprofessional. As long as you don't beat yourself up if the option is exercised because the stock rose higher than the strike price, it's not a terrible way to squeeze out a few extra dollars. You won't get rich, but conservatively done, you can add to your bottom line on stocks you may already own. No guarantees, but there never are.

I don't get all the concern about transaction costs. If you pay worst-case, say, $45 total for both ends of an option transaction ($10 stock buy, $15 option sell, $20 exercise), it's just a part of the trade. And often you won't get the $20 exercise ding, unless your strategy involves selling in-the-money calls. Always figure in the transaction costs as part of the upfront deal and you should be fine on that issue, it's not that difficult.

In my opinion, in the small scale trading you would do as an individual investor, options are not a terribly rational game to worry overmuch about in-depth research of pricing models. Options depend more on current investor sentiment than the stock market as a whole. In fact, it's a lot like gambling in certain respects (something you might want to watch out for if you have problem tendencies in that area).

You do need some volatility in the stock because otherwise its pricing is too predictable to make a large enough gain on the option sell. You don't want to grind out a sell stream of low-paying options, that's where transaction costs can kill ya and where reversals mount quickly. And, clearly, you want investor sentiment to be generally positive on the stock in the near term, because otherwise no one will pay much of a premium for your option. Just as important, if you strongly believe that the stock will really really rise in price, don't sell the option--just hold the stock for the later sale and higher gains. It's a judgement call. Obviously a rising stock market with positive sentiment is the best environment for selling covered calls, but that's trivially true for most market schemes.

For example, I sold an OCT 90 call on Amazon recently. Just this week, I've seen the price on the option cross the line above and below where I sold it twice. Today, AMZN is below $90. If it stays there, woo hoo, I made about $400 on the option sale free and clear. If it shoots above, well, I still made $400 on the sale plus a few hundred at exercise on the price I paid for the stock itself (below $90). Even if AMZN shoots up to $110, well, so what, I made decent cash. Good enough for me.

Personally, I would never sell (or buy) an option more than two months in advance, maybe a month. The future is too uncertain in both directions nowadays. And if you're going the trickier route of buying new stock to sell covered calls on, try to make it a stock you wouldn't mind holding longer-term if it dips for a bit. Do avoid the "I have to make my money back on the stock no matter how low it goes and how long it takes" mindset, though. Eat the loss when prudent. Also, don't be afraid to buy back your option if it drops before expiration to lock in a smaller profit and free up your stock for another option sale later.

If do you try covered calls, keep reminding yourself that when you make real dollars, you don't lose virtual dollars "if only" you had done this, that, or the other thing. People love to obsess over what they could have made letting a stock run when locking in a price on a covered call. Yeah, and you could have lost it, too. In the real world, real dollars always trump virtual dollars. Actually, this is true for any market transaction, not just options.

Covered calls might not be a good fit for you, but they can work for small investors.
posted by mdevore at 4:52 PM on October 2

There is no "right" answer to this question, as it is equally as unpredictable as asking someone if you should buy, sell or short a stock right now (or, more broadly, invest or withdraw from the equity markets).

You need to understand fundamentally that the purpose of writing covered calls is if you think the value of a stock will remain similar to where it is now or decrease slightly; it is a way to juice extra return under that circumstance. If you don't believe (or wish to speculate) on this happening, then don't write the calls. It's really that simple. People go long on equities because they have a fundamental belief that over long periods of time their value will increase (or dividends will continue); it's the safe and logical bet to make, assuming you believe in the market at all.

Another thing to consider is taxes. If you have deep unrealized gains in a stock and sell a covered call, are you ready to take the tax hit if your stock gets called away? (Though, you could always re-buy it within 30 days and I think your basis resets, if I recall the rule correctly).
posted by jameslavelle3 at 9:23 PM on October 2

I have a follow-up on my stock example to stress a point only lightly touched upon previously. Amazon has been quite volatile lately, so I bought back my OCT 90 call at $1.93 when it dipped into the mid-high 80's, clearing an actual profit of around $200 on my original $400 sale. AMZN returned to >90 levels by week's end and I subsequently sold a NOV 95 call.

The point of this update is that the safe option strategy of selling covered calls need not be a fire-and-forget situation. A conservative approach will entail keeping an eye on the stock, at least with price and news alerts, and buying back your option before exercise if circumstances warrant. Here, cutting in half the original option profit by buying it back on the dip allowed me to free up the stock for another option (or outright) sale, increasing both actual and potential profit.

Of course, often there is no opportunity to do something like this, but it's not extremely rare. You should not consider selling covered calls as strictly a passive investment strategy, one that forces you to wait for the binary resolution of exercise or expiration regardless of interim changes.
posted by mdevore at 9:13 PM on October 9