writing (i.e., selling) covered calls

what it means

Writing a call means entering an option contract in which you agree to sell shares in a stock to the counterparty at a specified price, if called upon do do so during a specific time period.  “Covered” means you own the stock in question. (See my post on calls and puts on stocks for more information.)

why do it?

You get a fee, called a premium, for doing so.

It’s possible that you feel the stock is at a short-term high point and likely to decline, but you’re a long-term holder and don’t want to sell.  By selling a call that you believe will expire unexercised, you collect a couple of percent of extra income.

It’s possible that you feel the stock is significantly overvalued and want to sell.  Selling a call that you feel is bound to be exercised nets you a somewhat higher price.

It’s also possible that your action isn’t an isolated decision–that you maintain an options overlay on top of your entire stock portfolio as a way of generating extra income.

two main presuppositions

In any event, the act of selling covered calls has two main convictions behind it.   Explicitly or implicitly, you believe:

–it’s better for you to forego possible capital appreciation in return for extra current income, and

–you’re able to make accurate judgments about whether stocks are cheap or expensive in absolute terms (that is, not just in relation to one another–see my post on relative and absolute performance).

why most professionals don’t do this

Professionals compete with one another on their relative performance, not their absolute returns.  So they’re not used to thinking or acting in absolute performance terms.

Absolute stock price judgments are harder to make than relative ones.

In many cases, the contract with customers won’t allow options purchases and sales.

To make a noticeable difference in overall performance, a professional portfolio manager would have to write calls on a large portion of his portfolio.  This is risky.  Early in my career I worked for a manager who had been one of the super-stars of the Seventies.  Beguiled by a then-prominent technical analyst, he became convinced that the big bull market that started in mid-1982 was a bear market rally.  So he sold calls on the majority of his portfolio.  The stock was all called away.  His performance was destroyed for a half-decade as a result, and he faded into oblivion.

why it may make sense for individuals

Although the strategy may result in lower total returns, individuals may well have a preference for income find that it fits their investment objectives.

In my experience, individuals don’t have fifty- or one hundred-stock actively managed portfolios.  They have far fewer positions.  So it’s at least possible that they get to know the short-term trading patterns of what they hold better than a professional who has much different objectives.  In other words, an individual may end up being good at this.

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