My son was visiting me this weekend. He told me that he had had 1000 shares of Bank of America, and it had been inactive for a long time and was at about $21. As I understand it, my son decided to sell a covered call, but to be safe he went up $5 to $26. He figured he had nothing to worry about because it hadn’t moved that much in ages. He only got paid $100 for his call because it was so far out of the money. He thought it was an easy $100, and that there was no downside.
Guess what. The stock price is now at about $32. To make $100 he lost $6000 profits, 60 times what he was paid. And to buy his call back to sell the stock he’d have to pay at least $6000, so he is going to wait two more months for the stock to be called, during which time he can’t sell the stock and reinvest the money elsewhere.
He said “Never again!” He said: “People like me win with a call like that a couple of times and think “It’s an easy $100, easy money, but it’s like picking up pennies in front of a steam-roller. One time I miss 60 times what I’ve been gaining taught me a real lesson. And I think, the stock could have gone to $40 and I would have lost 140 times what I got paid.”
The key take-away is that he’d have had to sell that covered call 60 times successfully, to make up for this just one time guessing wrong.
…but it’s like picking up pennies in front of a steam-roller.
This analogy is inapt. In no way was he damaged, he’s just making less profit than he would have otherwise. Being run over by a steamroller is a whole different thing! Writing covered calls is utterly safe and boring – you’ve just capped your upside.
-IGU-
(been run over by a steamroller writing naked puts – not safe, not boring)
“And to buy his call back to sell the stock he’d have to pay at least $6000, so he is going to wait two more months for the stock to be called, during which time he can’t sell the stock and reinvest the money elsewhere.”
Of course, he could just buy the call back for the $6000 and then sell the stock at $32 which would free up the money for reinvestment. And he would be $5100 richer than he was prior to selling it (the strike price was $5 more than the current value then).
Also, if he really thinks the stock could go to 40, then he would be giving up another $8000 by selling now - buying the call back would be a good investment. Although perhaps his judgement on the future stock price may not be any better now than it was when he wrote the call.
If only we could know in advance what the market will do, we would all change our strategies.
Rule # 1 for calls - don’t write them if you wouldn’t be happy to lose the stock at the strike price.
Your son’s experience is unfortunate. My key take away is: understand that options carry risk that can be in excess of owning a stock. Sizing positions and understanding how options work prior to investing will help immensely. Kind of like doing DD on a stock prior to buying it…
Saul,
Agreed, it is unwise to use covered calls unless you are holding a stock that you don’t think is a good investment or are absolutely ready to sell. Covered calls can be a great option if you have identified a solid dividend payer that you believe won’t be going anywhere for a long time. Then you can augment the dividend with call income to get a decent, not stellar return.
Personally, I want to invest invest in great companies so I can’t bring myself to look for those types of opportunities. I love calls to reduce risk on a company who’s stock price should swing widely from a special situation (e.g. Phase 3 results for KITE, Medicare/Medicaid reimbursement approval for FMI). In those cases, the risk of options is far lower than owning the stock IF one limits the options contracts to represent the same amount of stock they would have purchased with a direct investment.
Your right. It’s better to avoid options completely than to misuse them. Also, if we have a violent market downswing and you have the majority of your money in options you can wipeout your nest egg so IMO limiting naked calls or puts to no more than 3% (initial investment) is wise.
However, using options with a measured approach is better than not using them at all. I typically reduce my risk and add about 5% to my return with trades 2-3 x per year.
I know that my returns are far lower than yours, but options definitely improved my returns, and I think using them in measured, small, infrequent, but appropriate situations would help most people on this board.
The cautionary tale is that one should learn about options before trading them just like one should learn to drive before driving and learn about guns before shooting. Don’t blame the tools, blame the unprepared craftsman.
There is no such thing as easy money, all trades have their risks. My rule for selling covered calls is to make sure the strike price is high enough that I’m satisfied selling the stock at that price. The risk you run is lost opportunity, not lost money.
Calls should be sold when volatility is high. 2017 was bad year for selling covered calls
but it’s like picking up pennies in front of a steam-roller
Totally agree, Saul. Some years ago, I sold BBY put option repeatedly and happily collect the premium all the time. I thought I was really smart since BBY was a good company, even the price drop and I get the stock, it won’t be a problem. Then the price just collapsed. BBY seems had no future at all due to competition from Amazon. I got all the stock and had to sell. That’s the biggest loss of my investment career. Never touch option again. Option is a trading tool and should not be confused with investing.
The key take aways are really: 1) never, never, ever write calls on stock you don’t want to sell at that strike price or write puts on stock that you don’t really, really want to own 2) He made $100 on an offer to sell $25,000 worth of stock thats a return of 0.4% (or 0.5% on $21,000) he should have sold the stock out right and put the proceeds in a FDIC insured account or better yet one of your great ideas, 3) There Ain’t No Such Thing As A Free Lunch. Like all investing, options are a tool that can be misused if you don’t have an idea what your target company is worth or could be worth and what option strategy is best suited to your thesis for the company.
What was the catalyst for the run-up in the stock? It caught your son by surprise. He was just keeping his eyes on the share price, something I do too often, too.
Your son is better off than if he had simply sold BofA for the apparently “stuck” price of $21. (You must be talking about the period from January to September 2017. Right after that, the stock climbed again.)
But he’d be even better off if he had sold it off and bought Nvidia or Shopify or Arista or LGIH…
How would he feel with the call in place if the stock had gone down to something like $19, making the call cheap to buy back, but with lower paper profit in the stock.
Long run view: does the recent run-up in the stock mean that it’s now good to hold rather than sell?
Another consideration: buying back the call at a loss gives your son a nice fat short term capital loss for tax purposes.
And - you son could have opted not to sell the calls (or only sell a few instead of many), since the additional income was pretty low. Or he could have done some kind of strangle or collar, something I’m trying to get myself to learn how to use.
I think a quote from the knowledgebase is appropriate here:
You don’t have to be right about the stocks you sell, just the ones you hold in your portfolio. It simply doesn’t matter what happens to a stock after you sell it.
Your son had stock at $21, and sold it at $27 ($26 plus the call premium). That’s 28.5% in what, a few months? Sounds like a big win to me.
"And I think, the stock could have gone to $40 and I would have lost 140 times what I got paid.”
What a call does is commit you to selling at the price you agree. When he sold the call he was committing to selling the stock at that price. The same knowledgebase “doesn’t matter what happens…after you sell it” advice applies.
Your son had stock at $21, and sold it at $27 ($26 plus the call premium). That’s 28.5% in what, a few months? Sounds like a big win to me.
Thanks Smorgasbord, that’s a good way of thinking about it. (He sold it at $26 though (that $100 on 1000 shares only comes to 10 cents a share premium).
This is simply seller’s remorse. When the option was sold, your son was happy to sell BOA for $27 net $26 strike plus $1 premium). The fact that it went up beyond that is immaterial.
Just as you sold HDP or UBNT shares and then saw them rise past your sell point. When you decide to sell, you move on.
Investors know this. Ain’t nothing new under the sun.
I used to trade options far more often than I do now. Nevertheless, when confronted with similar situations in the past, often bought the options back with the proceeds of rolling it up and out. This strategy doesn’t always work, there are a lot variables, but it worked for me more often than not.
I never, ever sold naked options of any sort. Still don’t.
I’m sorry to hear that. Selling covered calls is, without a doubt, the single worst ‘retail’ options strategy there is. Give up the vast majority of the upside, keep virtually all the downside, and pay short-term gains taxes for the privilege while no retail investor would ever know if the price he’s getting justifies the risk-reward ratio.
If you want to reduce your risk in a position, sell the stock in part or whole.
Selling calls is, by very definition, a return-reducing strategy. That’s why the market is paying you to make the trade. And the market makers are paying you less than the position is worth, thus the bid-offer spread.
Selling puts is even worse, but most retail doesn’t qualify for that.
My son was visiting me this weekend. He told me that he had had 1000 shares of Bank of America, and it had been inactive for a long time and was at about $21. As I understand it, my son decided to sell a covered call, but to be safe he went up $5 to $26. He figured he had nothing to worry about because it hadn’t moved that much in ages. He only got paid $100 for his call because it was so far out of the money. He thought it was an easy $100, and that there was no downside. Guess what. The stock price is now at about $32. To make $100 he lost $6000 profits, 60 times what he was paid.
My son learned that he didn’t have it so bad after all. He has an acquaintance who had had short “uncovered” put options, going into yesterday’s (Monday’s) opening (meaning the guy was betting on the market going up). He didn’t have anything to cover the options. His account was worth $900K and he had a margin call for 1.2 million. His total portfolio got wiped out in a day by the leverage.
My son had two conclusions. His own problem wasn’t so bad after all, and he had enough of playing with options, although of course he knew that what he was doing wasn’t as dangerous.
He has an acquaintance who had had short “uncovered” put options, going into yesterday’s (Monday’s) opening (meaning the guy was betting on the market going up).
That sounds like most of my holdings. Yeah, Monday was pretty nasty. Let’s look at what happened to my position in SHOP recently.
I’m short SHOP 2020 180 puts, betting on it going up. If SHOP is over 180 at expiration in 2020, the puts are worthless so I get to keep my money. At the end of January they were at $63.95. And now, four short trading days later, they are at $68.10! I’ve lost $415 per contract! However, since they started January at $81.65, I’ve gained $1355 per contract for the year.
Admittedly, putting all your money into naked puts is a bad idea, as illustrated by this over-leveraged fellow. But I don’t think it’s quite fair to condemn a whole program because of a single slip up.
