Stocks - "covered calls" What is it and how can you loose on them?

Factual Questions
1

I have a friend who has been going on for about 2 months now about how “easy” it is to make money on covered calls in stock market.
I’ve been trying to figure out how this works, but my knowledge of stocks and trading is woefully lacking and I am having trouble understanding how these things work.
He has a former coworker who quit and is making all her income out of doing this (according to him earning 7K off 100K investment last month).
Now I am a bit of a worrier and I always expect that there is another shoe to drop, so I can’t help but doubt all the claims on the websites promoting this procedure that you “can’t” loose.

So I ask those in the know, what are the downsides to covered calls? What can go wrong? What are the limits to it/what stops every investor from using this process to get rich if it’s so guaranteed?

2

Here’s the Wikipedia article on covered calls.

I don’t understand a word of it. This is why I stick to index funds.

3

A call option is basically an agreement that if the price goes up the buyer (the other guy) can buy the stock from you at the old, lower price, he pays you money up front for that right. If the price goes down the buyer does nothing and you have the stock and the price of the option.

A covered call means you own the stock, then sell a call option on it. ETA: this is much much safer than selling a naked call, where you may have to buy a stock that just went up 50%, then sell it for the old price, Yikes!

Let’s say you have $10,000 of stock and sell an option worth $1,000 against it that is good for 3 months. If the stock stays the same or goes up, you earn $1,000 on your investment. If the stock goes up to $20,000, you still earn $1,000. The downside is that you don’t get to reap the benefits if the stock goes way up.

If the stock goes down, you earn $1,000 (what you sold the option for) minus however much the stock went down. If the stock goes down to $9,500 you earn $500, if the stock goes down to $5,000, you only lose $4,000. The benefit is that you can mitigate some of your losses if the stock goes down.

If the stock doesn’t change price that much, you’re guaranteed earnings, but if the stock price changes a lot, you still lose on the downside (just not as much) and you don’t get much at all on the upside (since you’ll be selling at the old price when the option is excercised).

You also don’t get to diversify very much, since you need a large amount of individual stocks on hand to cover the call. I’d say this is ultimately less risky than just owning stock, since it tends to moderate your wins and losses, but it’s nothing special.

4

Quite simply a call option is the right to buy stock (usually 100 shares but we’ll keep it at one to exposition) at a fixed price (known as the strike price) on or before a given date. So for example, if a share of stock is selling for $100, you migh tbe able to buy for $10, the right to buy the stock for $110 on or before Dec 31st. If the stock rises to $117 you will exercise the option paying $110 to get something worth $117 (of course your net profit is -$3 since you paid $10 for the option in the first place.

Writing covered calls is owning the stock and selling calls to someone else. You profit in just the scenario I outlined by on net selling the stock for more than you could outright. You also profit from the call writing if the stock price drops and you can pocket the enitre $10 and not lose the stock. You’ve los money on the stock, but in total not as much as you would have.

So where’s the catch. The catch is that your “losses” on the option are not actual cash losses, but opportunity losses. If the stock price rises to $130, the option will be exercised adn you’ll only have $10 + $110 instead of $130.

Writing covered calls usually comes out a bit ahead, but when it comes out worse it often comes out quite a bit worse. Your friend’s experience is typical. He’s made a bit of money, but in the next big movement of the market, he’ll regret writing covered cals.

5

so if I understand correctly, it’s all still dependent on having well performing stock (since no one will buy or sell bad stock)? Also, you won’t make much unless you’re operating with large figures (such as this girl with her 100K)?

Either way, you have to invest a lot to gain any benefit from it, and if the market dives (and you’ve got a lot tied into it) its more likely to hurt.

Am I close?

6

Not quite. If you sell a call, you profit more if the stock does not go up, because then nobody will buy the stock from you.

An example with made-up sample numbers:

You own 100 shares of SDMBA (Straight Dope Message Board, class A) stock. SDMBA currently trades at $30. I pay you $5 per share ($500 total) for the right to buy those 100 shares of SDMBA at a strike price of $35 on or before June 30. I have bought the call option, and you have written the covered call option. No matter what happens, you pocket the $500.

If SDMBA goes over $35 between now and June 30, I will exercise my right and buy the 100 shares of SDMBA from you at $35, and possibly sell them at the higher price. I gain (in pocket if I sell, on paper if I hold the stock) the difference in the stock price. You lose the opportunity cost of the higher market price.

If SDMBA doesn’t go over $35 between now and June 30, the option expires. I’m out the $500; you keep the stock. If SDMBA is between $30 and $35, you have a paper gain relative to the original price. If SDMBA is below $30, you have a paper loss.

Then we can turn around and do the same thing with put options, which is the right to sell / the obligation to buy a stock at the strike price.

7

You’d want to write a covered call if you expect the stock you own to suffer a downturn (or be flat) in the short tern, but will rebound in the long term (i.e., after the calls expire).

Let say you bought stock at $15. If the stock is now at 20 and you expect it to stay that way, you can write a covered call for $30. You’ll get paid when someone buys the call (say for $5). If the stock doesn’t reach $30 when the option expires, then you get the $5 and still have the stock. If the stock goes over $30, you have to sell it, but you’re making $35 a share (the $30 stock price plus the $5 you were paid for the option). If the stock goes over $35, you have lost (you could have sold your stock for that price), but it’s not money out of your pocket.

Covered calls are used for hedging against a temporary stock downturn. It’s fairly safe, since (assuming you originally bought the stock at a lower price than the strike price) you’re making money on the deal – just not as much as if you didn’t write the call. The reward for that risk is the $5 you’re getting for writing the option.

8

Covered call writing is a fairly conservative strategy as far as options trading goes. They are often used to increase income on income equities that historically are less volatile therefore less likely to exceed the strike price.

9

You’re not that close just yet. Basically your first position is to own a bunch of stock. Stock goes up you make money, stock goes down you lose money, simple. Next, you sell this option on the stock you own, and lock in $X of earnings on day 1 of the project. Then you wait, if the stock goes up, you earn $X, regardless of how much it goes up. If it goes down, you earn $X minus however much it went down, so you lose less than you would have otherwise lost. This assumes the strike price is today’s price, which is the simplest case.

It’s actually less risky, with less variability in how much you’re going to earn/lose, than if you just plain old owned the stock. But, you give up the ability to earn a lot if it goes up a lot to guarantee a payoff on day 1.

10

ok, I THINK I’m getting it, so then, what sort of event (fluctuation?) would have to happen to lose money? For example, I gather from what my friend’s friend is doing that her stock is spread around, what sort of losses would she have to take to loose in the long run?
Also, what sort of initial investment would return enough to make it worth while?
I know she somehow borrowed the initial 100k (don’t know what terms) but she made enough to cover the initial interest and eventually enough to start earning an income from this.

11

In a given period, if the stock price drops more than you sold your option for, you lose money. You also lose out on an opportunity if the stock price goes up more than you sold the option for.

How much to make it worthwhile depends on how much you need to earn, how much time you put into it and what the costs are to do the transactions.

I’m having trouble understanding exactly how she can earn $7k a month on a $100k stake, given this strategy. That’s 7% a month, which is crazy high earnings, but the strategy is one that is more conservative, with less upside potential, than straight stock ownership. That doesn’t compute.

12

She’s been doing this for a while now. That may have been the initial investment and she has more money involved at present.
I’m getting this information 2nd hand remember (from someone with about as much knowledge of this as me).
I’m trying to schedule some time to talk to her but I wanted some background knowledge going in, just so I can ask intelligent questions.

Thanks guys.

13

The notion that it’s easy to make money doing this is ludicrous, of course.

The people who are buying the calls your friend is selling probably also think it’s an easy way to make money, and they can’t both be right.

If you’re friend isn’t deeply involved in the world of options pricing (which is almost as complicated as it gets in the world of finance, AFAIK) then in the long run, she is going to lose money. There are people out there who probably know more about pricing then she does, and she’s probably paying fees to a broker every time he trades.

14

Writing a call on stock you own (a covered call) will lower your downside risk (you’ll lose less if the stock price falls) but limits your upside reward (you can only profit up until the price of the call). If she writes a call at Current Price (CP) + $10, then she lose all future profit potential once the stock goes to CP + $11.

We recently had a discussion about the market being a zero sum game. Options truly are zero sum. If your friend makes money, someone else is losing money. That’s not to say that all losses are bad. I could purchase out of money calls because I’m short a stock, thus limiting my potential losses at the cost of decreasing my potential gains. Personally, I would consider that a healthy loss, as it is protecting you from the potentially unlimited losses of owning short stock.