Please help me understand this.

Discussion in 'Options' started by Nater, May 26, 2012.

  1. Nater


    Excuse me for the very long and somewhat rambling question, but I had to make sure I had every detail covered.

    So I've been reading much on options, and I have been trying to wrap my head around the many different types of options strategies. One such strategy that I've been trying to understand clearly is the covered call. Please excuse my over-explanation, but it is important I understand all of this thoroughly and correctly.

    An in-the-money call will cost the the intrinsic value plus the time value. So, if, for example, I owned 100 shares of a stock that I bought at $10 each, and I sold and in-the-money call option with a very low (and very deep in-the-money) strike price, I'm basically selling my shares plus profiting from the time value automatically, correct?

    Let's say for the example, I sell one call option with a strike price of $2 when the stock is at $10. The profit from the option will be $8 (in intrinsic value) plus whatever time value is on there (let's say, for this example, it is $0.25, which seems like a fair price for an option that expires in a couple months). When the option gets exercised (either by assignment or when it expires), I will have made a total profit of $25 on the entire trade (($2 X 100) + ($8.25 X 100) - ($10 X 100)).

    Assuming all this is true (which, of course, I am not sure it is), then couldn't one just quickly buy 100 shares of a stock, and sell the call option for an almost certain, albeit small, profit? I mean, there is still the risk of stock price falling below $2, but that risk seems so small that it seems like a sure thing. Even if you take out the cost of commissions (which, judging by your broker, could be around $10), you are still in a very good position to make a profit.

    Perhaps I am over simplifying everything, not judging the risk appropriately, not taking in account some other fee I am unaware of, or something else, but this trade seems very sound. The chances of the stock actually dropping below $2 during the life of the option is so low, and I guess this is why the profit is so low. But if this strategy was multiplied by, say, 100 times the amount of contacts, then the profit would be $2,500 (minus commissions).

    And also, if the stock were to start falling unpredictable towards $2 a share, couldn't you just sell the option and the shares before it actually hit $2 per share? Although your profits from the option is going to be lower than if you would have let it expire, it could still be profitable because as the stock fell in price, the option would fall accordingly, right? Or, at the worst, it could limit the losses.

    Although the profit seems very small, the risk seems to be smaller. Am I missing something here? Cause having a stock fall more than 80% during the life of an option just doesn't seem likely enough to deter the small profits that could add up. If you do sell a call option that is in-the-money, isn't it going to at least net you a small profit every time?

    An example of all this is The Boeing Company (BA). It is currently at $70 a share, and it is selling call options that expire in November with a strike price of $40 for $31.35. By selling that contract (and assuming you had 100 shares of BA bought at $70), you are guaranteed a profit of $71.35 per share. Right? And I know the profit is limited to this, which is fairly low (seeing how the stock can easily move above $71.35), but the chances of the stock's price moving below $40 dollars (or, to be exact, $38.65, an almost 50% loss ) is very low and could easily be seen a mile away. Right? Adding in costs from a cheaper broker (I'm getting the examples from OptionsHouse), that would be ~$8 to buy and sell the shares, and ~$9 for the option, and $7,000 for the shares, rounding up to a cost of $7,020. Since you would make a profit of $7,135, your net proceeds would be $115. And although this is only a gain of ~1.9% for about a 4 month investment, the risk was so small that it seems worth it.

    Now, I haven't started trading options yet, for I am still trying to learn as much as I can, but I just wanted to know if what I am saying is right. Although I would probably not trade for such small gains, and the strategy I presented seems impractical, I only need to know if my theory is right.
  2. Your problem is that you're thinking you can sell at the ask price of 31.35 - the bid/ask is 29.70/31.35 and you'd probably be lucky to get 30.30 - the midpoint is 30.52 and you're not going to get 30.50 ...

    If you're going to do covered calls you have to ask yourself if you're a good stock picker and if you're good at picking the direction of the market.

    Don't ever write calls (or sell naked puts) on stocks you don't want to own at a given price ... you will regret it. Promise.

    Covered calls have their place but it has serious limitations. Unfortunately it seems to be a simple idea and a path to easy money. Not so.

    It's actually very complex. It involves picking a stock to own and then selling off the upside to that stock. When and why would you want to do this? In very limited circumstances for sure.

    Like anything else having to do with options you won't really know how it works until you've been through a number of cycles and stocks. Do yourself a favor and do it on paper for at least a year... more like 2. If you do it for real you'll only lose money those first two years anyway.

    You need not only to sell the calls, but also you need to buy the stock and not overpay for it. Most beginners who do covered calls overpay for the stock, sell the calls too cheap and then watch the stock drop and lose money. My rules for CC:

    1. get the stock cheap (e.g. by selling puts)
    2. sell calls at the top, not the bottom
    3. use single stock futures instead of stock to cover the call

    By the time you get all of that you'll have discovered other strategies that are better.

    By the way: Covered calls and short puts are the same thing
  4. Unless you already have the underlying stock, you're always better off just selling a naked put vs. buying the stock (commish, carrying cost), selling call (commish, slippage etc.). Risk reward is the same, think about it.

    Remember, options are a very, very simple.

    All the best,

  5. Don for an experienced investor I would agree but for anyone new to options I would say that covered calls are much better.

    The problem is that new investors are not savvy enough to follow how much margin they are using up and when the stock or market moves against them they tend to blow out. I have heard time and again from reps at major OLB's that naked puts wipes out more people then anything else.

    Talk to service reps at the Money Show or somewhere where nobody else is listening to get an honest answer.
  6. I have to really, really, beg to differ. The Money Show people are generally not real traders, and have no real experience.

    Options are so simple, and we use the "covered write = naked put" scenerio to determine if someone has a clue about options.

    All the best,

  7. So how would the naked put position wipe out an account, while the covered call doesn't?

  8. Your average punter can usually get more exposure to the underlying through a naked short put than through long-stock-on-margin.

    Thus faster blow up with the short puts.

    Nothing to do with put-call parity .. just more conservative on the long stock margining. :p
  9. Respectfully, I completely agree with Don..

    One difference in the two positions is who is bearing the "unlimited" risk - the trader or the firm. I laughed hard when I realized this for the first time - naked puts are RISKY!!! and covered calls are a prudent strategy for the sophisticated investor. They don't care about your account money at all but put 10 dollars on the line for their firm and they get queasy. (Corzine may be an exception.)

    Two issues I have noticed with beginners are: trading options cuz they're cheap and the amount of knowledge needed to trade them well.

    The same people who would not trade their entire account on one bet feel fine trading futures or options wide-open buying everything they can on one bet. This is a misunderstanding of leverage principles in my view given a losing trading game and the certainty of a loss in the future somewhere.

    Give me any stock price one month in the future 100% certain and I will retire in a month using one trade!

    Also, many retail traders think like this - options are easy - buy a call if the stock is going up and buy a put if it is going down. Easy Peasy. Some say, I never trade options, they are risky. When asked why they don't know, but know that they are risky! (My 80 year old uncle touched an option once, and he was dead 5 years later!)

    Sadly though Don, some traders are much simpler than the options they trade.
  10. Don I said talk to the reps at the Money Show from the major OLB's - some might be hired hands and have no experience with customers, but some are real reps.

    If you call say Ameritrade and ask a rep they won't be forthcoming with any type of answer about how people blow out accounts.

    I was part of a Fidelity focus group some years ago and they told us the same thing.
    #10     May 28, 2012