How to Write Covered Calls, Part 4 – The Reality

To conclude this series on covered call writing, I’d thought I’d offer some pointers from my experience. 

While it is “possible” to make 20-30% per year writing covered calls, I’ve found that the actual returns tend to be far less.  It is easy to look at the 90 day call and imagine yourself collecting that premium every few months, resulting in that 25% return.  There are some issues with this, however.  These are:

1) The bid-ask spread.  As I said in a previous post, the spread – the difference between the bid price and the ask price – for options tends to be large.  When writing a covered call, expect to only get the bid price for the sale.  Likewise, if you need to buy the option back, you’ll pay the ask price.  The option specialist gets to pocket the spread by buying the options from you at the bid and selling it to someone else at the ask. 

While stock price spreads have narrowed considerably since the days when shares were traded in fractions rather than pennies, 1/4 point, 1/2 point, or even larger spreads are fairly common for options.  Given that you’ll only be collecting $1-$2 per option contract, 1/2 of a point will take 25% to 50% of your profit each time you write a call.  For this reason, try your best to not close the transaction – instead allow the calls to expire worthless, rather than covering when the price drops to low values even though it is tempting to write the next set of calls.

2) Commissions and Taxes.  While brokerage fees have fallen quite a bit, often less than 1% on a stock trade, option commissions still tend to be 5-10% of the option sale price.  Likewise, option trades are considered short-term capital gains, and therefore are taxed at regular income levels.  This can carve off another 25%.

3) Market volatility.  Sure, it looks great.  The stock is at $32 per share and you are able to sell 3-month 35 calls for $1.75 each, or a return of $7 per year per share.  But after you write the calls the stock goes up to $36, then $38, then $40.  Your calls, which you sold at $1.75, are now worth $6.50 per share and there is still 1 month to go before it expires.  Because of the increase in price, you need to keep extra cash in your account that is not earning any interest.  

Do you bite the bullet, buy a 35 call, and then write the $40 call, trading at $2.50 per share, to recoup a little of your loss in the option premium?   If you do this, you will have lost $6.50-$1.75-2.50 = $2.25 per share on the option position but would have gained $8 per share due to the stock going up in price, resulting in a net gain of $5.75 per share on the trade.  Remember that you were writing covered calls, however, because you felt the shares were overpriced, and now you are effectively adding $2.25 to the price you paid for them.  If the price falls from $40 per share back to $32, you will now be looking at a loss instead of breaking even.

The opposite can also happen, where the share price falls beyond what you received in premiums, resulting in a loss.  You could then buy back the calls, paying brokerage commissions again, and write a new set at a lower price.  What if the stock then shoots back up, however?  By lowering your strike price, you are lowering the effective price at which you are selling your shares, locking in the loss on the stock.

In general, while covered call writing is tempting, I usually find that I do better just holding shares outright.  If I think a stock has good prospects, limiting my potential gain by selling the gain above some strike price to someone else rarely makes sense.  Likewise, if a stock is overpriced, it is often better to just sell it since the price swings can often easily outstrip any premiums collected from writing calls.  Nevertheless, I sometimes write covered calls anyway to remind myself of why I rarely write covered calls.  It does have some entertainment value, is really good clean fun, and is a lot safer than Vegas. 

This is a continuation of a series of posts on covered call writing.  The series starts here:

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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