A Look At Covered Calls - 6 Months In

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.

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Although I haven't posted in a while and didn't update May results, I have been recording the hypothetical trades in real time. It is now six cycles with a bull phase and bear phase included. This has been fortuitous as it has been handy to show largely what I have been wanting to demonstrate about covered calls.

Going back to my original motivation for this simulation, it was to expose the nonsense of the ubiquitous advertising line that one could make 4-8% income every month from this strategy.

This simulation is not the perfect example of how everyone would trade covered calls, but by now shows the problems inherent in the strategy as a systematic income generation machine.

I should point out that I am not against covered calls in the slightest. I use them (or the pure version of the strategy, the short put) frequently when I want that particular risk profile. I have some long term holdings that I sometimes write calls over when I think it is appropriate, but never systematically every cycle.

The fact of covered calls is that they are optimally profitable when the stock moves sideways. They under perform their underlying market in strong up-trends and outperform their underlying market (though may still make losses) in down-trends. Over the long term they reduce volatility, but depending on the greater trend there is no guarantee that they will be outperform the underlying.

I do not believe picking and choosing tickers (systematically) works any better than picking and choosing underlying stocks in a trading system.

Several 'educators' try to rework the numbers by altering the moneyness of the options, most frequently by writing deep in the money. This increases probability of profit, which feels good to the investor who enjoys large numbers of wins, but dramatically reduces the maximum profit. It also dramatically increases the size of the (abeit fewer) losses as a proportion to the typical win.

It changes the nature of the equity curve, but not the ultimate expectancy. It's a bit like a martingale system. it feels like you have found the holy grail for a while, until you get run over by the proverbial steam roller.

OK lets look at the graphs of the individual stocks I am using along with the total list of trades with the last two month's trades beneath the screen split.

As at close of trading June 15 2012:

Goldman Sachs

After six months trading, an impressive run up, an equally impressive swoon, we are essentially back where we started with both the underlying and the covered call strategy. All we have managed to achieve is to reduce volatility.

But this is a classic illustration of how CCs under perform the underlying in up-trends and outperforms the underlying in down and sideways trends. 

National Oilwell Varco

NOV has not been that dissimilar to GS, excepting that the CC strategy has managed to augment our equity by 5.5% over the six months. That's not a bad result for a buy an hold investor, but a far cry from the 4-8% per month as claimed by the seminar clowns.

Freeport McMoran

FCX represents the most significant out-performance of the three stocks selected at ~7.5%, but really has only trimmed the nearly 9% loss on the underlying to 1%. If you are invested in FCX on a buy and hold basis, that is a significant achievement... and that 7.5% is cash you can use for a festive dinner with friends and family, or reinvest if you prefer, but still nothing like the "buy my $3,000 covered call course" promoters claim.

Yes some of the returns in individual months were 4-8%, but mostly at the cost of even greater returns from the underlying. In other words investors trying to pick uptrends to write covered calls would have been better off just buying the underlying.

However, there is still good times to write calls in up-trends. One can dust off their crystal ball and write calls  a bit out of the money at points where the underlying is overbought and likely to retrace or consolidate in the time frame selected (time til expiry).

As shown, they also partially hedge in downtrends. But the best use of covered calls is if you can see into the future and pick when your stock is going to go sideways.

Overall, a useful strategy for investors, but sub-optimal for shorter term traders.

A Look At Covered Calls - Cycle 4 Round Up

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.

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I have now wrapped up cycle 4 of the covered call simulation and the results get more interesting, but not unexpected on my part. The motivation for this sim is the representation of easy money available through trading covered call. Although this is not a perfect example, it is generally representative of the ebb and flow of trading this strategy.

I've tried to represent an augmented version of CC trading, via rolling at times within the cycle, to pick up more premium if possible. Most times this works, but sometimes it screws up at we shall see below with FCX.

Let's start of with GS:

The stock is off 10% (relative to starting price in Dec 2011) and the cycle's movement is shown by the red box.

I was able to roll the calls dow, collect most of the original premium, plus the additional premium as it expired OTM. A 6.4% cash profit from the option premium. This is set against the 10% fall. Although the covered call outperformed buy an hold in this cycle, the covered calls still made an overall loss. Buy and hold over the four cycles is still outperforming covered calls at this stage.

FCX was the screw up for the month from a trading perspective. The stock is down just ~2.5% for the cycle:

This is CC manna; write calls get sideways movement collect the premium and buy a holiday to the Bahamas on the proceeds at the end of the cycle. But when this whipped down to around $36, I traded the April $40 calls for $36 calls (Which I neglected to record on the blog. Like GS above, it would have worked well if it lingered down there, but it didn't. It whipped back up again causing a loss when closing out ITM on the second lot of short calls.

C'est la vie.

Cash profit for the cycle 0.65%, less the loss on the stock and we are again behind a bit. Nevertheless, the covered call strategy is in front of the stock over the four months by an eyelash.

Lastly, NOV was down ~9% over the cycle:

I rolled this twice and closed the third lot as it was slightly ITM, getting nice chunks of premium from each resulting in ~5.6% cash profit. But like GS, the dumpage of the stock caused an overall loss for the cycle. Like GS, the covered calls are making gains on buy and hold, but after four months, buy and hold is still a few lengths in front.

The overriding point at this stage is that in a non-margined account, there is still no net cash income from the covered calls. That would be disconcerting for someone sold the dream of reliable cash income from covered call trading.

A Look At Covered Calls - April 11 Update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.

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Just as this market was getting so complacent (relatively) that I was starting to doze off a bit, it throws in a half decent swoon, startling me from my daydreams. Now I find that the stocks I follow... and the index itself at levels of time and price support, I find myself pondering upon some adjustments.

As my covered call stock sell off, the extrinsic value of the call options have reduced, my positive theta is now relatively less, and the positions have built up some extra deltas. I can buy them back at a profit and re-sell ATM again to pick up more premium or leave them to expire .

If indeed the market does get some support here and we get a bounce going into expiry, those extra deltas are going to help the overall position. On the other hand if the market steps of into the abyss, they're going to hurt.

Writing new calls ATM will bring in more extrinsic, reduce delta and will partially hedge downside. On the other hand it opens the risk of taking it once again on the intrinsic value of those short calls if the market bounces.

This introduces a new question: Does the systematic covered call writer want to be an analyst as well, or just write premium at points where he can get it most. If I hark back to the original idea of this, it was to show a hypothetical portfolio to collect premium. .

Well as it's a hypothetical account, it doesn't matter much and the idea is to see different scenarios in real time, so I did record some adjustments earlier.

With GS trading at 116.13 I bought back the April 125 call for 56c and sold the April 15 for $3.40

I also adjust the NOV position; with the underlying at $78.33 I bought back April 80 call for 57c and sold the April 77.50 for $1.32.

NOV Adustment

Just an adjustment I recorded on the covered call project; last Thursday with NOV trading at $78.93, I bought back the April 85 call for $0.61 and wrote the April 80 call for $2.21.

A Look At Covered Calls - Cycle 3 Round Up

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing) with a non-margin account.

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We are starting to get some interesting results from the covered call project as not all of the stocks are continuing to go vertical.

I've slightly changed the format of the spreadsheet and added a chart; Last week my hard disk started splitting atoms and nuked itself, so decided to reconstruct them this way. It should give a better longer term view as we go along.

Goldman Sachs is the one stock from the three continuing to rocket northward so the story here is a repeat of the last two cycles. That is, the covered call is making money, but less than if we just held the stock, the short call losing on intrinsic value.

Last Friday at $122.19 GS was well in the money so to avoid assignment I bought back the call at the ask for $7.16 and wrote the April $125 call for $3.05

We're 18% up, but with 14% cash losses on the short calls we'd be grimacing if we had a non margin account. Yes we've made 6% per month which seems to validate the seminar cretins on the face of it, but deeper analysis reveals a different picture.

When a stock is on a strong uptrend, the covered call effectively halves (give or take) returns and gobbles up spare cash.

From FCX we get a totally different picture this cycle. The stock has retraced much of the gain seen in the first cycle. We made some nice cash from the calls. After rolling the nearly worthless Mar 44 down to the 40 and the forty expiring worthless, we made nearly six and a half percent. But the cash gains over the last two cycles have only paid for the losses on the first cycle and we've lost money on the stock. Overall the covered call strategy is level pegging with buy and hold at just over four percent. I wrote the April $40 call for $1.20.

Still no nett cash in hand profit after three cycles.

The covered call strategy has reduced volatility but still no cash in hand.

NOV has been in the sweet spot for this cycle as far as the covered call strategy is concerned, i.e. write the call, stock goes sideways, call expires worthless, pocket the premium and have a festive dinner with family and friends... seminar cretin nirvana with four percent cash in hand return this cycle. This is the situation the covered call is best for long term holders of stock.

If only you could predict that. But if you could predict that accurately, bugger the covered call, you'd cash up the stock, mortgage the house, the business, sell your first born male child and plonk on as many short strangles as they'd let you have and retire rich

Additionally, if I was trying to flog a bullshit course on covered calls, I would cherry pick this months results as an 'example' of how to get rich with covered calls.

Over the three cycles thus far the picture of course is different, still down eleven odd percent on the cash position and still behind on buy and hold, even though we are up nineteen percent overall.

We will need a few more sideways months to make this look good. I wrote the April $85 call for $1.71.

Overall a pretty good month for the project as readers can see what happens when the stock is not going straight up.

A Look At Covered Calls March 5 Update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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A couple of our sold calls have very little extrinsic value left after some downward movement in the stocks, so time to roll down and pick up some more extrinsic.

With FCX trading at 40.01, I bought back the March 44 calls for 15c and sold the March 40 calls for $1.20.

With NOV trading at $79.52, I bought back the March 85 calls for 27c and sold the March 80 for $1.52.

No action on GS.

A Look At Covered Calls - Feb Cycle Catchup

Geez I've been bloody slack at updating this blog. With my business plus looking at properties I've been as busy as a one armed taxi driver with crabs and writing bullshit in the Interwebs has taken a back seat.

Anyways time to catch up on how my covered call project is doing so I'm harking back to February expiry here to detail the trades I recorded at that time. Firstly my normal lead in:

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

GS First

The Friday before expiry GS was trading above our 115 strike so with GS at 115.49 I closed out the 115 call so there was no risk of assignment. I am making the assumption that these are long term holdings and that we don't want assignment, which will precipitate a capital gains tax event. I paid 91c on the ask and lo! We actually made some cash profit on the call.

So with GS our CC strategy has under-performed in the first two cycles by greater than 10% which is to be expected as the stock was still basically on a rip. It was the sideways movement after the last roll where we ended getting some cash from the short put.

I wrote the March 115 for $3.95

FCX

This one expired slightly out of the money with the stock at $44.09, pay dirt as far as income from short calls is concerned and with no rolls during the cycle, pretty simple, we got a buck fifty two and put it straight in the bank.

By virtue of the underlying going sideways all month, ending a buck or so down and getting reasonable premium for the call, the FCX CC strategy has done quite well this month, trimming back about half of the under-performance against just holding stock. Which of course means the CC has outperformed this month. This shows the best use of covered calls in a portfolio, when the stock is going sideways.

If only we knew that in advance.... :-P

I wrote the March 44 for $1.31

NOV

For some reason I can't remember, I closed this one out on the Thursday before expiry with the stock in the money at $84.07, the loss of intrinsic value eating up the gain from extrinsic value, plus a bit; thus taking yet another loss on the short calls. Our under-performance on NOV has been worst of all with the stock increasing at a strong clip over the two months I've been doing this simulation at -15%

We're still 15.4% up, but just holding stock we would have been up 30%. Worse still, if we are not operating on a margin account, we would have received no income from this and in fact would have taken away from our cash position. 

The seminar cretins didn't tell you that did they.

I wrote the March 85 for $2.57

A Look At Covered Calls - Groundhog Day

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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Groundhog Day - Well that's what it seems like, closing out short calls pre-expiry for a loss and rolling up to gather up a little more extrinsic value. The adjustments are increasing our profit from the covered call strategy, but not enough to keep pace with the rise in the stock.

Essentially we are taking it where the sun don't shine on the intrinsic value of the short options as our stocks relentlessly rise.

I didn't have time to update live again, but on Friday I recorded a couple of adjustments.

GS continues to rise in essentially a straight line since inception of the strategy, so once again to tweak the collection of extrinsic vale, I rolled from the Feb $110 calls to the Feb $115. Once again, we lose on the intrinsic value, but collect the bulk of extrinsic ahead of time and writing closer to the money for some more extrinsic.

Here's the state of play:

NOV presented the same opportunity so we rolled from the Feb $75 to the Feb $82.5

No action necessary on FCX

A Look At Covered Calls - GS On A Tear

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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I have another adjustment for GS placed on the Friday 27th. Essentially Goldman is on a tear and rocketed up the the next strike,trading at . This means we can pick up some more extrinsic at $111.81.

The 105 call we wrote at $4.45 I bought back for $7.85 once again taking a hit on intrinsic value of the option, even though we've made some on the extrinsic. Chalk up another situation where we would have been better off with just the stock (so far).

I've noshed up a spreadsheet to keep track:

No action on NOV or FCX

A Look At Covered Calls - The End Of The First Cycle

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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I've been very busy with my non-trading business and haven't had the time to post here as I would have liked, but I did record some adjustments in the intervening time.

But anyway, we've now come to the end of the first cycle of this project and good news, we've made a profit. I'll get to the bad news later.

FCX

FCX continued to surge higher and with the shares at around $42 I rolled the Jan39, taking a loss of $2.63, out to Jan42 and collecting $1.40 in premium. On Jan 11 we also got a $0.25 dividend which we must add to the results.

Last Thursday I closed out the January calls (as I wasn't going to be around Friday and do not want to be assigned) for $2.30, taking another loss on the short calls of 90c. Underlying was trading at $44.51.

Overall on our FCX covered call strategy we've made ~10.5%, an awesome result until we look a bit deeper.

• Had we have just held the shares, we would be 19.9% up! So the covered call strategy has cost us 9.4% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

GS

GS continued to surge higher and with the shares at around $100 I rolled the Jan95, taking a loss of $2.97, out to Jan100 and collecting $2.73 in premium. 

Last Thursday I closed out the January calls for $6.25, taking another loss on the short calls of $3.52. Underlying was trading at $106.55

Overall on our GS covered call strategy we've made ~8.9%, another awesome result until again we look a bit deeper.

• Had we have just held the shares, we would be 15.2% up! So the covered call strategy has cost us 6.3% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

NOV

Last Thursday I closed out the January calls for $5.50, taking a loss on the short calls of $3.14. Underlying was trading at $75.36

Overall on our NOV covered call strategy we've made ~8.2%, yet another awesome result until once again we look a bit deeper.

Same situation as the other two:

• Had we have just held the shares, we would be 16.9% up! So the covered call strategy has cost us 8.7% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

These are the Feb calls I wrote for the next cycle:

• FCX Feb12 45 call for $1.52
• GS Feb12 105 call for $4.45
• NOV Feb12 75 call for $3.25

Still early days, but what we can glean from this first cycle is that covered calls cost you potential profits in strong uptrends and though still profitable, do not give you any cash income. You could just let the options expire in the money and be assigned in which case you would realize the extrinsic value of the options, but you would only realize cash from the stock to the value of the strike price.

Any way you look at it, the covered calls have cost us money so far.

We're Not All About Covered Calls

By the way, for those who have followed me over from my previous blog and any new readers that have found me, it might seem we're all about covered calls here. We're not.

There's lots more stuff to come.

A Look At Covered Calls - Jan 9 update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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FCX has been lingering around the $39 mark for a few days now. The Jan $37 calls have about 30c of extrinsic, whereas the ATM $39 Jan calls have around $1.00 of extrinsic.

The question is whether to pick up another 70c of extrinsic while losing the $2.00 of intrinsic hedge we have at the moment. I say stuff it, let's do it, we're all about premium collection here and damn the downside risk. :-P

I'm buying back the $37 calls at the offer of $2.52, a loss of 20c, and selling the Jan $39 for $1.17 with FCX trading at $39.21. So we're $1.89 to the good with the covered calls while just holding the stock would have us $2.09 in profit at this stage.

No action on NOV and GS.

Covered Call Are Naked Puts - The Proof

In my previous post I made the assertion that a covered call IS a naked put, synthetically. In this post I'll prove that with an example.

Firstly, it is important to know that every call option has a relationship with it's corresponding (same strike and expiry) put option as proven by and equation called the put/call parity equation. For your information, this equation goes like this: call price - corresponding put price = stock price - strike price + interest - dividend (if any).

It is not merely theoretical and we know this exists in the real traded market, because any anomalies in this relationship would be closed by arbitrageurs quicker than you can say 'Jack Robinson'. If for example call prices were too expensive compared to the corresponding put, arbitrageurs would sell the call, buy the put and buy the stock in equal proportions in a position called a conversion. This would guarantee a risk free profit. In reality, this is not achievable by a retail trader, so we can trust that option prices are in line with each other.

But I digress...

Let's suppose on Dec 15 2001 Tom the Trader wanted to collect some premium and had the view that GS would stay roughly where it is at around $92.50 or trickle up a bit until mid January 2012, so he sells 3 $90 Jan put contracts at $4.10, a face value of $27,000 (the amount Tom would have to cough up for the shares if assigned) and collecting $1230 in premium... a 'dangerous' naked put position.

If GS is above $90 as the January expiry date, Tom keeps his $1230 and pockets a tidy > 4% on the face value of the contracts (or > 12% on initial margin if you prefer looking at things that way {I don't}).

But what of the risk? What if Goldman has finally been caught out with one of its dirty deeds and the price collapses down to $70.00 by expiry? Well Tom could always cut his losses and exit before expiry, just like any trader can, but let's suppose Tom is a deer in the headlights and freezes?

Well Tom will most certainly be assigned the stock and will have paid face value for the stock, less the premium collected; a total of $25,770 for stock now worth $21,000. A loss of $4,770.

Ouch! Risky!

On the same day in Dec Tony the Trader thought it would be a great idea to do a covered call on GS, so buys 300 stock at $92.48 and sells 3 calls at $6.65. He pays $27,774 for the stock and collects $1,995 in call premium, bringing the cost base down to 25,779. Notice anything about similar about the put scenario yet?

If the stock closes anywhere at $90 or above at expiry, Tony will most certainly be assigned and will be paid $90 for the shares, collecting $27,000 ( a loss of $774) but will keep the $1995 call premium. This is an overall profit of $1,221.

But once again, what are the risks? Using our $70 at expiry scenario as we did with Tom's naked puts, Tony would be left holding stock now worth $21,000. He's lost $6,774 on the shares, but keeps the $1,995 call premium; an overall loss of  $4,779

Ouch! Risky also!

In each scenario the profit or loss of both traders is only $9 different to each other and this is accounted for by the interest accounted for in the option pricing model.

Pick any number at expiry and the profit or loss of these two scenarios will always be only $9 apart. Once interest for holding stock is accounted for, the result is the same. Because they are the same.

A covered call IS a (synthetic) naked put.

Covered Calls - The Naked Truth

Seeing as I have kicked off this blog by following a hypothetical portfolio of covered calls, I thought I'd have a bit of fun with a thought exercise. This is something every option professional knows, but many option noobies have a bit of trouble with.

We all know what a covered call is, long the stock and short calls in equal proportion. For example, if we Own or buy 100 of XYZ stock, we write 1 call contract.

Covered calls are variously promoted as a conservative option strategy, almost risk-less, easy monthly income and a host of other soothing adjectives and superlatives.

On the other hand, naked short puts are often castigated as being highly risky, having unlimited risk, dangerous, gambling and perhaps even having the potential to give you heart disease and herpes.

The overarching message is covered calls - good, naked puts - bad. Most covered call traders are quite comfortable with the strategy... initially at least. These same traders probably reach for their crucifix and don a string of garlic immediately naked puts are mentioned.

Unless you are au fait with option synthetics, you might be wondering why I'm talking about this.

It's because a covered call IS a naked put. Or more accurately, a covered call is a synthetic naked put. They have the same risks, same reward, same payoff diagram. If you are trading covered calls, you are ipso facto trading naked puts.

The only caveat to that is that the the strikes and expiry must be corresponding. So if you have a covered call with a $95 strike and March 2012 expiry, you in fact have a naked short march 2012 $95 put.


Need proof? I'll go through the maths in a later post.

A Look At Covered Calls Jan 4 2012 Update

So here we are on Jan 5 on our first covered call cycle, with a couple of weeks to expiry. I'm updating today because a couple of these positions now have very little extrinsic value left and could be rolled up to pick up a bit more extrinsic.

As to the P/L situation, I took the snapshot of the market a little earlier and this is how we stand:

GS

The stock is trading at 95.51, up 2.2% since inception last month

I rolled the option and got $5.95, a profit of $0.70 a further 0.75%, combined profit  of 2.95% so far. So for GS we are at this stage just a little bit further ahead with the covered call strategy.

I've gone and written the Jan12 95 call for $2.93

FCX


The stock is trading at 39.75, up 7.1% since inception last month

However our Jan12 37 call is $3.35 at the offer, an open loss of  $1.03 (not worth rolling this one) and 2.8%. For the strategy we are up $4.3%

Yes, around that magic 4% profit mark at the moment, but lo! We would be better off just holding the stock at the point.

NOV


The stock is trading at 70.49, up 9.4% since inception last month

I rolled the option and got $5.90, a loss of $2.45 which is 3.8%, combined profit  of 5.6% so far. So for NOV we are at this stage behind with the covered call strategy, even though on the face of it we are above the 4% per month thing

I've gone and written the Jan12 70 call for $2.36


I stress that at only a couple of weeks into this, these results are fairly meaningless and only worthy of reporting because of the adjustments. As we get a few months into this, it will get a lot more interesting.

A Look At Covered Calls - The Naked Truth

Perhaps the most promoted of all option strategies by both spruikers and brokers, is the covered call (Long the stock and short a call options in equal quantity). The most irritating aspect of this promotion is the disingenuous representation that returns of x% a month are available by systematic writing of covered calls over a base stock holding, ranging from 4% to 8% per month.

That's a lazy ~50% to ~100% per year. Nice!

But is that accurate? Barring random outliers, no it's not, but noobs get sucked in to this dream in their droves.

What I want to do is hypothetically pick three stocks from different sectors and systematically wrtite "at the money" calls on them, to see whether the 4% +  per month dream is valid.

I'm starting off with GS, FCX and NOV. I will write calls every month at the available bid and we'll even roll when jucier  extrinsic is available at other strikes when the stock has moved somewhat. I'll sell at the available offer.

As I write, GS is at 92.48 so I have written a Jan12 90 call at $6.65. This a little bit in the money providing a little more hedge along with our premium.

FCX is at 37.12 and I have written the Jan12 37 call at $2.32

NOV is at 64.46 and I have written the Jan12 65 call at $3.45

I do not personally hold these stock and this is hypothetical... a paper trade, if you will.