I think some of us here are mis-interpreting anxvariety’s statements about options. It is not easy to make money in options but the covered call strategy he noted is an excellent way to “enhance potential returns without incurring additional risk on capital”. I’m bored at work so let me waste my employer’s time and give an example. Let’s borrow Powayseller’s long term position in COP as a basis for our discussion.
Let say your current strategy is buy-and-hold for the long term so you bought COP and stick the statement in a drawer and go on a 2 year vacation. This buy-and-hold strategy implies that you expect COP to EVENTUALLY rise even though as a rational person you do know that it will fluctuate. And this strategy limits your upside potential to the point-to-point return of the stock, i.e. if you bought at $100, then it goes to $150, then back down to $120 then up to $200, your return is limited to $100 per share or 100%. As a greedy person (aren’t we all ?) you ask, is there a way to make more than 100% in this scenario without taking on more risk ? I dare ask this question because YES THERE IS !
Now let’s refine this simple buy-and-hold strategy with covered call. In order to do this, it’s best that you have an objective measure to help determine when a stock is temporarily expensive (for those subscribing Zeal, the stock price relative to its 200dma is as good as any and we’ll refer to it as the rCOP). So you mull it over on the excel spreadsheet and let say it tells you that everytime rCOP approaches 1.20 times its 200dma then the law of probability says COP will soon reach an interim top and gravity will pull it back down, albeit temporarily.
Now after you bought COP at $100 a share (hopefully $100 is near its 200dma so at least you’re not buying it when it’s technically temporarily expensive), you sit and wait until rCOP hits 1.20 which indicates the stock is near its interim top. Let say the price is $140 at this point, you write a covered call option on it with a strike that’s let say 10% above current price (so strike=$154). At this point, the buyer of the option will pay you the option premium. You will then face one of the following scenarios:
1) The life-is-perfect scenario: COP continues to rise to reach an interim peak of $150 before calling it quits and go back down to $120 and next thing you know the option expires. Result: you have a very very big smile on your face because you feel good that COP keeps rising and you made money (on paper at least), PLUS you got the option premium as the icing on the cake.
2) The not so perfect but still pretty darn good scenario: COP starts rising quickly as soon as you wrote the option and broke the strike price on the upside. Result: the option holder exercises the option and pays you the strike price of $154 for the COP shares. You have a medium size smile on your face because in addition to making money on COP shares (realized profits) you also made money from the option premium. Then you immediately buy COP shares again to re-establish your long term position, unless of course you then determine to time it and wait until it comes back down near its 200dma before you re-establish the position (remember if a rCOP of 1.20 is considered expensive, then 10% above that should be considered even more expensive isn’t it?)
Now of course if COP shoots up like a rocket your re-purchase price could be higher then the strike at which you sold the shares but hey who said life is perfect ?
3) Now what if COP falls ? After you wrote the option COP starts falling to $90, then $80, then ….. Well, it proves that your entry point for COP might be a bit premature (or you’ve completely missed the direction of the market) but since COP never hits the strike so you retain the option premium but hey you still have your COP shares, which is exactly what your original intention was anyway; thus the option premium effectively reduced the cost basis of your COP shares. And if you lost your nerve and sell the shares, you would lose less money thanks to the cushion created by the premium.
In all these three scenarios, provided that your ORIGINAL strategy is long term buy-and-hold, ADDING a supplementary covered call strategy will enhance your potential returns without incurring additional risk.
But then of course you can buy/sell options the way anxvariety does and whether it is riskier or not compared to just buy/sell stocks really depends on how you look at it.
