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Author: TWA40 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 11006  
Subject: Re: Writing LEAPS Covered Calls Date: 1/26/2001 1:53 PM
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I haven't visited here in about 6 months, and I had to chuckle at how covered calls still dominate the discussion, and how ttm and Rayvt still haven't given up in their crusade to bring wisdom to the masses. A toast, from me, to both of you.

Covered calls represent half-assed investments. You mentally equate the premium you get for selling away most of your upside potential as “downside protection”. But it's not real downside protection—which would come from also buying a put with the same strike price and expiration as the call. It's a funny thing about real downside protection—you have to pay for it; people certainly don't give you money to take it off their hands. But if you buy the stock at the ask, buy the put at the ask, and sell the call at the bid, you'll already be in the hole about $10 per 100 shares even before commissions. But aside from paying one more commission at assignment, at least it never gets any worse than that.

If you look at what the market maker gets for this put-call parity transaction across a number of different stocks, where he can sell the call at the ask instead of the bid, you'll see that he's only up about $25-40 per contract, on average. And that's before his albeit much smaller commissions and cost of capital. Let's call it $20-25 per front month contract, after all transaction costs. That's pretty thin gruel, although you could make a living at it on high enough volume. But you need to have the market maker's edge, of working in the pit, in order to get it.

Retail investors think they're getting an edge over the market maker because they “save” on the expense of the long put, but in so doing, they assume all of the downside risk. Unless there's something inherently wrong with the Black-Scholl's model, this so-called edge is naïve, to say the least. The only competitive edge a retail investor can bring to a covered-call transaction is an opinion about the direction of movement in the underlying that happens to be correct more often than not. Volatility, after all, knows no direction, but between now and expiration the underlying will either go up, go down, or stay the same.

If you think the stock will go up, why not just buy it outright, and reap the full gains from your uncanny intuition? If you think the stock will go down and you're selling a call because you need to obtain some “downside protection”, why not either: a) forget the call and buy a put to obtain some real downside protection, b) wait and buy the stock at a lower price, or c) sell a put and get assigned the stock if and only if it drops down to a price where you're more comfortable owning it, and then hold on to it to profit from the anticipated gain? I'll concede that if you have an uncanny ability to identify stocks that will go absolutely nowhere, then selling covered calls just might make some sense, but how about this instead? Take a black magic marker to the Wall Street Journal and black out all the stocks that you predict will go absolutely nowhere. Then go short or long on all the rest (assuming that someone who can predict “no movement” can at least accurately predict the direction of “a little bit of movement”).

If separated in time from the stock purchase, a covered call sale might occasionally make sense as an alternative method of selling the stock. Indeed, this is the only way it makes any sense. Use your “stock-picker's edge” to correctly predict an upward movement in the underlying, and then use a covered call to “sell it” if you can juice a little extra time premium out of the deal.

At this point, I'm truly honored if anybody is still following me. Let me summarize: 1) to obtain downside protection at the time of purchase, you need to marry your stock purchase with the additional purchase of a put, NOT with the additional sale of a covered call; 2) to make a decent profit, you need to correctly predict an upward movement in the underlying; and 3) when that move occurs, you should sell a covered call on the underlying. Now that is almost a sensible strategy. Almost, because it involves one more commission than necessary, and a whole lot more capital.

What you really ought to do is buy the calls you were thinking of selling at the time of your stock purchase, wait for the underlying to make its predicted move, and sell the calls when it does. And if you don't see that this is exactly the same as the former example, then you don't know enough about options to be messing around with them.

TA
A recovering covered-call-aholic
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