Hey guys. Someone just made a post about covered calls where he thought he'd discovered a risk-free way to trade them. For some reason, he deleted the thread, but my response to him took enough time to write that I thought I'd post it here. It might help those who are considering a covered call strategy.
The example he gave was selling January 2012 $15 Calls against GE, which is currently trading around $20.50. The options were selling for $6. His strategy was buy the stock, sell the calls, and then short the stock to protect his downside. I'm not calling anyone out here; it was a legitimate question deserving a real answer. Here is my response to him, and why that's a bad idea:
HAHAHA.No such thing as a guaranteed profit in the market, buddy. You might be looking at it a little backwards. Covered call writing can be an excellent income strategy, but it's a pretty weak means of speculation. The object of writing covered calls is to generate income from options that expire worthless. Therefore, I doubt you'd ever see a covered call writer sell an in-the-money option.
You bring up an interesting notion with shorting the stock as well as going long, but you're not factoring in the margin that shorting requires and the margin interest expense. On your specific example, your maximum upside should the stock get called away is $350 minus the margin and interest expense of your short position. So you're talking about less than a $350 profit (and more likely a small loss) on a $40,000+ trade in 9 months. Definitely not a good strategy.
Also, it doesn't matter if GE is trading at $15.01 on expiration day - you're gonna lose your stock if you have $15 calls granted against it. The market makers will literally take your stock for 1 penny at expiration. So the notion that someone paid $5.40 for a $15 call and therefore wouldn't exercise if the stock were at $16.50 is erroneous. In that case you would keep the premium you earned, sell your GE at a loss, and have that loss mitigated by your short position, less any margin interest.
A far better strategy if you're interested in writing covered calls is to find a stock you like and that you think is going to go higher, but you wouldn't mind owning even if it went lower. Buy the stock, go on margin to double your position in the stock (so, for example, buy 1000 shares of XYZ and then margin another 1000 shares) and then sell out-the-money calls against it a month or two from expiration (try not to go too far out when writing covered calls).
So, for example, I just went to coveredcalls.com and found out that XNPT (XenoPort, Inc.) is trading with a hefty call premium. So I can buy 1000 shares of XNPT today for $5,930. I then margin another 1000 shares, bringing my total position to 2000 shares. Then I write 20 APR $6 CALLS (currently trading at $1.50 apiece and expiring in 15 days) for a total net premium of $3,000. Just to recap: you've essentially paid $6,000 for the stock, and immediately collected $3,000 in premium. If the stock closes above $6 in two weeks, you keep all the premium, and make an additional $140 profit minus margin interest. Take a minute to annualize that return.
If the stock drops, however, look at what you've managed to do. You still keep all the premium, you keep the stock, and you've lowered your cost basis in the stock from $5.93 a share down to $4.43. Once the options expire in two weeks, you just grant the next month's OTM calls and collect another round of premiums, further lowering your cost basis.
Now that's how you work covered calls.
Hope that helps.
Could you theoretically lower your cost basis in the stock to/near $0 using this strategy?
You can go well below a 0 cost basis with this strategy, and I've done it a number of times. It all comes down to volatility and premium.
When selling a call, is the premium immediately collected? Or does someone need to have an open order for the call for it to be completed (e.g. limit order for an equity). Thanks Edmundo
As soon as your sell order is executed, you receive the money. So, for example, you own 1,000 shares of XYZ at $12 a share, and the June $15 XYZ Calls are selling for $1.25 each. You would sell 10 of them at $1.25 and immediately collect $1,250 in premiums (minus commissions, of course). If the stock remains under $15 per share at expiration, you keep all the stock and the premium. If the stock is over $15 per share at expiration, you sell your 1,000 shares for $15 per share, netting you a $3,000 profit in addition to the $1,250 premium you collected.
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