Believing Writing Covered Calls is Conservative

The entire options industry is setup to convince you selling covered calls is a conservative strategy. If you look at the option trading levels below you’ll see covered call writing only requires the lowest level of option trading approval, level 1. Most brokers and option advisors will recommend you start option trading by writing covered calls. Despite what your broker wants you to believe, I’m here to tell you that writing covered calls is NOT a conservative strategy. Come on say this 21 times with me, Writing Covered Calls is not a Conservative Strategy.

I’m guessing you’re not simply going to believe me without a persuasive argument. Yet you probably believed your broker with no evidence

For my evidence I offer:

1. Look up at the table again. Can you see what trading level uncovered put writing is?
   The second highest level of approval, level 4. Only uncovered writing of index puts and calls requires higher authorisation. Do you find that a wee bit strange? Writing covered calls and uncovered puts are identical option strategies from a risk reward perspective. If they are identical from a risk and reward perspective then why don’t they require the same level of approval? Covered calls is the first strategy most people are “sold” while writing puts is considered an advanced strategy that requires years of option trading experience. Odd, don’t you think?
2. Look at the following profit and loss (risk graph). Is this graph for a covered call or an uncovered put?
   Trick question. There is no way of knowing as the profit and loss, the risk profile, is the same for both. Limited upside and almost unlimited downside. When you sell a covered call you are selling the right to the upside while taking on all the downside risk.
   
   
3. Most people think selling a covered call is giving them some downside protection. The reality is covered calls do not protect the downside. The small downside hedge you receive in selling a covered call is in most cases outweighed by the psychological impact of having sold the covered call. If business conditions change and you should sell the stock, you are more likely to hold the stock rather than sell as your judgement is clouded and confused by the call you sold.

In summary covered calls are not a conservative strategy. They are amongst the riskiest of options strategies and should only be employed under specific circumstances. Covered calls do not protect your downside. They cap your profit leaving you holding all the downside risk and they leave you at the mercy of the market.

Here are my rules for writing covered calls.

1. Only write calls on stocks you own and are comfortable to continue to own.
2. Only write calls at a price you are happy to sell at. This should be your calculation of fair value or some margin above fair value.
3. As stocks generally move in spurts it is preferable to write a covered call after a run up in the price.

My rules when not to sell a covered call.

1. Never sell a call as an exit strategy. Absolutely never ever sell a call as an exit strategy. If a stock has risen to fair value or above and you do not want to own the company for the long term then sell the stock or enter a collar (sell a call and buy a put).
2. Never sell a call to simply to collect a high premium. If a premium looks high there is a reason for it and the downside will bite hard.

Covered calls are a good income producing strategy for long term stock holders. They are not a conservative option trading strategy.

Happy trading.

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1. Day Nine: Ten of the Biggest Mistakes in Option Trading
2. Day Six: Ten of the Biggest Mistakes in Option Trading
3. Day Six Part 2: Ten of the Biggest Mistakes in Option Trading
4. Day Four: Ten of the Biggest Mistakes in Option Trading
5. Day Two: Ten of the Biggest Mistakes in Option Trading
6. Day Seven: Ten of the Biggest Mistakes in Option Trading