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URL:  http://boards.fool.com/2nd-point-people-look-at-the-what-if-scenarios-of-25898651.aspx

Subject:  Re: Covered Calls Date:  9/13/2007  5:50 PM
Author:  Rayvt Number:  59179 of 75592

2nd point:
People look at the what-if scenarios of CC's but ignore the outlying cases. Naive investors tend to act as if low probability occurrances are ZERO probability occurrances. Alas, most of these people get taken out of the game when one happens. That's philosophy.

Beginning CC people say "If the stock goes up and gets called away, well I'll be happy to sell it for X above the current price." This is called whistling past the graveyard.

They say stuff like this to fool themselves: If it goes down, I'll take a loss on the stock but keep the premium--so I've lowered my risk. This, of course, hasn't lowered the risk, merely put less money at risk (stock price - received premium). You are still at risk for 100% of the money. And if it goes up, well I'd be happy to sell it at that higher price. And anyway, most of the time it'll only move a little bit and so I'll keep the premium and collect it every month.

But the rare times the stock takes a dump, they lose a lot of money--much more that the pittance of premium they've collected. And the rare times when it jumps up a lot, they've given away most of that jump.

How far OTM do you go for the call? 5%? 10%?
Just out of curiosity I took a look at the monthly price change in MO for the past 10 years (Jan 1997 to Sept 2007). 128 data points.
Number of times the month-month price was more than 10% loss: 14
Number of times the month-month price was more than 10% gain: 11
Number of times the month-month price was more within 5% gain or loss: 68

Maximum m-m gain: 23%
Maximum M-M loss: 34%

So roughly 53% of the time you'd keep the premium.
11% of the time you'd eat a large loss.
9% of the time you'd forgo a huge gain.

I further see that today MO closed at 67.13 and the Oct 70 call (4.3%otm) was bid 0.70 and the Oct 75 (12% otm) was bid 0.05.
Not a heck of a lot of premium to collect, especially after the commission.

I'd invite you to do the same figuring with whatever stock you like for CCs. It only takes a few minutes to download the historical prices from Yahoo and running the numbers into a spreadsheet.

Ray
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