While appearing theoretically sound and fundamentally safe, option trading strategies such as Covered Calls posses the same shortcomings as other short-term market timing activities.
Covered Calls
A Covered Call involves an investor writing (or selling) call options on an asset, while holding a long position on that same asset.
The strategy is a way of generating an income from options premiums using one's long-term investments; and is considered sound because it relies on low price movements, which are considered the norm for such investments.
The potential for loss too seems limited at first glance; since the most once can lose is a part of the profit from one's current holdings, and only when the price rises.
The Risk
The problem with a Covered Call is that, if the price goes up, one is forced to sell the stock to the option buyer at lower price.
This is exactly the kind of risk that a Benjamin Graham — or his student Warren Buffett — would warn against. Such a strategy may work nine times of of ten, but it will fail eventually.
All seasoned Value Investors warn against trying to predict short-term price movements. The fundamental principle behind Value Investing is that anything can happen in the market over the short-term.
The deceptive aspect of a Covered Call is that one predicts that the price will not move, and one only loses potential profits when the price goes up.
But while predicting that the price will not move may not seem like a prediction, it actually comes down to the same thing. One can also lose a significant amount of potential profits if the price of the stock rises; which again may not seem like a loss in theory, but is a loss in practice.
An Example
Let's take the example of a Covered Call for a lot size of 350 where the current market price of the stock is $50. One buys 350 stocks at $50 and writes a call for $55 at $2. One gets a premium of $700 in such a scenario.
Now, supposing the stock appreciates 20% to $60, one sells the stock at $55. At first glance, it appears as if one has received both a $5 profit and a $2 premium; for a total profit of $7 per share.
But in reality, one loses the remaining $5 per share; for a premium of $2 per share. So overall, one loses $3 per share.
The Trade-Off
The basic trade-off of a covered call is that one loses the potential for full long-term gains from the stock's price rise, in exchange for a steady income from options premiums.
The deceptive aspect of this strategy is that it may seem as if there is no loss, because one doesn't lose money; one only loses profits. But in practice, a loss of profits is also a loss.
No Called Strikes
One of the biggest advantage of being an investor, is that no one can force one to buy or sell at the wrong price.
“In the securities business, you literally every day have thousands of the major American corporations offered to you at a price and at a price that changes daily. And you don’t have to make any decisions. Nothing is forced upon you. There are no called strikes in the business.”
While speaking here in the context of buying rather than selling, Buffett is still referring to this very same fundamental advantage of investing; the opportunity to profit from inactivity.
Graham too has referred to the same advantage of never being forced to sell; but again, in a different context — that of not letting oneself be emotionally influenced by external factors such as recessions.
Covered Calls Excepted
But with a Covered Call strategy, one loses this most important advantage of choice. Now one can be forced to do something. When the price moves up, one is forced to sell one's holdings; and that too at a lower price than the stock price, thereby incurring a loss of profit; which is a loss nonetheless.
Perhaps one could speculate with this strategy using penny stocks, or other cheap stocks which have poor fundamentals and are unlikely to rise. But it would definitely not be advisable to risk one's primary value portfolio on such a strategy.
Videos
Buffett - No Called Strikes
The following Buffett clip on No Called Strikes is from Adam Smith’s Money World: How to Pick Stocks & Get Rich that aired in 1985 on PBS.
Peter Lynch on Derivatives
Here's Peter Lynch explaining why he avoids derivatives altogether to Charlie Rose in 1997.
Submitted by GrahamValue. Created on Wednesday 12th February 2020. Updated on Friday 26th August 2022.