Much of what you are told about covered call writing, even by many so-called “experts,” is wrong – or, at least, less than 100% accurate. This week, we explore ten myths about covered call writing that you may have heard. Perhaps the key word here is “always,” as in always explore your alternatives - rather than always pursue exactly the same strategy.

1. Always write out-of-the-money covered calls on non-volatile stocks.

This a good strategy if you know for certain that the stock is not going to move.  But nothing in life is certain. Bristol Myers Squibb Co (BMY), for instance pays a dividend yield of 4.47% per annum.  With the stock at $28.70, you can write the September $31 call against it and bring the yield up to 7.36%.  But this might not be the best strategy.  According to our model, the call is priced way too cheaply with a premium of only $0.12 versus our estimated premium of $0.45 (see Figure 1 below).  Over the past year, BMY has traded over a 12% range, having hit a low of $24.95 in April and a high of $29.56 on July 21st. The call offers only 1.07% downside protection, which is not much considering that BMY has incurred monthly losses of more than 2% in 23 of the 84 months of the past seven years.

Figure 1 - Options Profile on the BMY September $31 Call

08_12_11 10 Covered Call Myths - Figure 1

2. Always let your calls expire worthless if they are out-of-the money.

Many investors assume that all options have their fastest rate of time decay just before expiration.  That is not always the case with out-of-the-money calls.  Often they tend to reach a low premium “junk” level several weeks before expiration, offering little in the way of further yield or downside protection. The cost of rolling these calls can be a lot less than many people think, especially if the bid/ask spreads are reasonable.  Often, one can narrow the spreads even further by entering a price limit on your rollover order.

3. Always let your stock get called away if the call is in-the-money.

Often investors are reluctant to incur a cash loss closing out a short call that has moved in-the-money, and are therefore willing just to let their stock get called away. You do not need to do this, however.  Even if the call is in-the-money, there is a good chance that you can roll it to a later expiration for a credit, and not have to spend cash.  Often, you can find the new positions that have attractive combinations of yield, protection and profit potential.

4. Always write short-term calls against your Stock.

Shorter-term covered at-the-money covered calls offer you the best results if the stock doesn’t move very much. However, there are plenty of instances where the shorter-term covered call will underperform the longer-term covered call on the same stock with the same strike. If the stock rises sharply, the longer-term covered call is less likely to give up some of the upside, while if the stock falls precipitously, the longer-term call will, in most cases, give you more protection.

5. Covered calls are always riskier than stocks.

In fact, they rarely are.  Most studies show that covered call writing is less risky on average than just owning stocks, with steadier cash flow and fewer losses. However, covered calls have some risks of their own. The first risk is the so-called “opportunity risk.”  That is, when you write a covered call, you give up some of the stock’s potential gains. One of the main ways to avoid this risk is to avoid selling calls that are too cheaply priced. 

Another risk to covered call writing is that you can be exposed to spikes in implied volatility, which can cause call premiums to rise even though stocks have declined. However, you still will be able to keep the original premium at expiration.

6. Covered calls are always better than cash-covered puts.

Because it involves owning the stock, many investors assume that covered call writing is always preferable to writing cash-covered puts.  True, there may be some cases where it might be easier to exit a covered call than a put write, but in most instances, the risks are the same.  Often, the yield and the protection offered by the premium can be the deciding factor on whether to do the covered call or the comparable cash-covered put.

Also, the strike price of the option and your expectations are important. If you expect the stock to end up below the strike price, then you might prefer writing the covered call, since if things go as planned, you do not have to buy back the call. Alternatively, if you expect the stock to end up above the strike, then the cash covered put may be preferable because the put expires worthless.

7. It is always bad when your stock gets called away before expiration.

In many cases, early exercise of your in-the-money short call can be a gift.  This is because you are getting more money delivering the stock at that strike price than you get if you simultaneously sold your stock and bought back the call.  The only time you stand to lose is when there is a ex-dividend before expiration.  If the call gets exercised before the so-called “ex-dividend date” (i.e., the date in which the holder of the stock is identified to receive the dividend), then you lose your right to collect the dividend.

8. Always avoid writing covered calls in volatile markets.

Often selling premium, when the rest of the world is buying it in panic, can be the best thing you can do.  First of all, there are times when put buying is just too expensive, and the only viable hedge is to a write a call on your stock.  Often, the reward/risk potential of such a transaction is very attractive. Our track record tends to show the best performance for covered calls following dips in the markets.

9. Always avoid combining covered calls with other option strategies.

There is no reason why covered calls cannot be combined with other strategies. For instance, many investors write a portfolio of covered calls and then hedge themselves against stock market risk by buying less expensive index options.  Other investors combine put and call purchases on other stocks along with their covered calls. Our track record data suggests that such allocations can help the portfolio when stocks make a big move in either direction.

10. Covered calls are always unsuitable for Retirement Accounts.

Quite the contrary!  Covered calls are almost ideal for retirement accounts such as IRAs, since they offer income and protection. Moreover, the unwanted tax consequences that can occur with covered calls in regular investment accounts are almost never a problem in retirement accounts.  Most brokers allow covered calls and cash-covered puts writing in IRA accounts, and many allow option purchases and limited risk spreads as well. (See “Using Options in Your Individual Retirement Account,” Ot090323.pdf in our Reports Archive.)

Prepared by Lawrence D. Cavanagh, vloptions@valueline.com

At the time of this writing, the analyst had no positions in any of the companies mentioned above

Figure 2 - Some Useful Option Strategist Reports

08_12_11 10 Covered Call Myths - Figure 2