Rip West writes:
> Contrary to some posts on this subject, options do not have to be
> 'shooting craps'. Dealing with covered calls does not have to be
> overly speculative. On the other hand, I would be very interested to
> hear from people who use this technique if the results overcome the
> the commissions involved. Has your experience been good? And how about
> those cases where you wrote a call, and the underlying stock went up
> drastically. I know of one, in particular, dealing with Apple. Any
> more stories on that?

I'm sure Rip wants to hear my opinions on options. He views me as the fount of all knowledge on accounting, too. [ROFL]

I spent quite a bit of time selling covered calls. I used software to calculate the rate of return for different strikes. This allowed me to compare apples to apples. Here's an example from 2005 when I was futzing with this stuff:

With this table, I could see what my "insured" value was. That's the "Covered" column. It tells me that if I sell a covered call at $50, the price can drop to $49.16 without me losing money (including commissions for the options and the underlying). Remember that the option is still valid at that point so you can't just sell the stock without being "naked". If the stock keeps on dropping, you can always buy back the call, but it will cost you some money. For example, it would have cost me $.65 per contract to buy back a $60 strike price even though stock was trading at $55.66 on that date.

I liked the idea of insuring my long positions. If the stock went down, I made money, because the option would expire worthless. The commissions were definitely covered by the gain. However, there's still a risk that the stock drops dramatically, but in that case, the market has probably collapsed and you are screwed even if you have an ordinary long position. The option buffers the loss a bit, but there's nothing you can do to stop the loss on the underlying itself.

Rip wanted to know what happens when the stock goes up. The answer is: I win! However, you have to have no regrets. In the above table, I could sell a call at $60 and make 8.85% absolute return (including commissions) if the stock hits $60 and the call is assigned. How this works is that I get the original $0.65 for selling the call, and I get the difference between the purchase price (Last trade $55.66) and the strike ($60 which is $3.34. This works out to a 64.61% annualized return. There's a big caveat here, explained below.

However, if the stock goes up to $65 I "lose" the extra $5. The call buyer gets that premium, and more power to her, because she risked way more than I did. She made a fabulous return, for the incredible risk she took. It's like buying a lottery ticket for $.65 and hoping (that's all you can do), you win, that is, the stock goes up before the option expires worthless. If the price doesn't go up, you lose all your money. That's a risk I'm not particularly interested in taking, and I'm always amazed that there are people out there willing to take that particular risk. Good luck!

There are a couple of caveats to this strategy. For example, you need to have some open interest, or you aren't going to be able to sell the call at the price of the Last trade in this table. That's important, because if you can't buy at that price, you aren't going to make the return calculated in the table if the stock goes up. You'll have to buy at another price, which may not be nearly as favorable. For example, there's no way you are going to get a 187% annualized return for selling a $70 call at $0.05. It ain't gonna happen, and so you shouldn't even try. There was no Volume on the option, and the open interest is likely to be too low.

The bigger caveat is that the Annualized return figure assumes that you are fully invested and that the underlying hits the strike price. To answer Rip's question again, if the stocks are going up very rapidly, this is a profitable strategy, then again, if the stocks are going up, you don't need to be selling covered calls. You are going to be very rich, because your crystal ball is perfectly accurate.

As we know, nobody can predict which way a stock will move so the theory of covered calls was invented to help people insure their positions. When you buy insurance, you are giving away money to reduce your risk. With covered calls, you are also locking yourself into a position and limiting your upside while reducing but not eliminating the risk on the downside. It's a tricky business, which requires incredibly rational behavior. You can't be married to stocks. You almost certainly need software to help you out, because the margins are very small.

I stopped options trading in 2005. I figured out that my time was better spent writing software, because I have more fun programming than calculating returns on options. That's obviously a personal decision about how you spend your time.

If you do trade options, please read Mark Wolfinger's column Know Your Options. I read his book, too (see his bio next to his column), and found it very clear and straightforward. He is happy to answer questions about options trading, and I don't think I've met anyone more knowledgeable about how options work.

Disclaimer: statements are opinions expressed by me These statements are not intended to replace professional advice. When in doubt, follow the advice of your investment, tax or legal advisors who are familiar with your particular circumstances.

Options and short sales involve risk and are not suitable for all investors. You can sustain losses in excess of your invested capital when trading options or short sales. All investment club members should understand the risks of any form of trading or investing. To learn about options, we recommend visiting the Options Learning Center at the CBOE. To learn about stocks, please visit the Investor Education area of the NASD.