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Strategies & Market Trends : The Covered Calls for Dummies Thread -- Ignore unavailable to you. Want to Upgrade?

To: Mathemagician who wrote (1937)	8/12/2001 2:07:59 AM
From: Uncle Frank	Read Replies (1) \| Respond to of 5205

Impressive analysis, MathMage, but before I get a headache trying to work through it, is the egg worth the candle? By that I mean, based on your familiarity with the thread's participants, their goals, level of sophistication in the options arena, and current market conditions, would you recommend we substitute strangles for covered calls? >> At the risk of being unpopular... No risk of that. We need smart guys here so we can cheat off their papers :-). duf

To: Mathemagician who wrote (1937)	8/12/2001 9:23:03 AM
From: rydad	Read Replies (3) \| Respond to of 5205

Mathemagician, I just spent a good 15-20 minutes typing out a reply/rebuttal to your analysis and by the time I finished and was proof reading it, I realized I came to the same conclusion as you. However, I would like you to verify the validity of an additional statement that I feel should be mentioned. Maximum loss occurs when the share price reaches zero. But this is the point that I am trying to prove to myself. After this stock market thrashing we have taken over the past year or so, how much further can we go down? I know that everyone tells me this is dangerous thinking and I realize that even another 20% or more is very easily possible. But what is the probability that a stock will go to zero? Anyways, wouldn't you think that we are closer to the bottom of the market than the top and if we did get a substantial further dip, eventually we will head upwards again. Just out of curiosity, do people still believe the market will come back up again some day? Otherwise why are we putting our money in stocks if we think it is dead money forever? I am hoping the downturn is not eternal and I am biding my time by writing calls and learning all these new strategies from you all. Having a great time here on CC4D Respectfully Ry

To: Mathemagician who wrote (1937)	8/12/2001 9:14:04 PM
From: Dan Duchardt	Respond to of 5205

dM, I guess the bottom line is that it seems to me that the two strategies are equivalent since a position in one can be replicated using the other. (Can Dan or someone prove/provide a counterexample?) If this is true, any discussion about which strategy is superior has little hope of ending well. Maybe, maybe not. Your analysis appears flawless. There is a precise mathematical equivalence between a buy-write with an exact ATM covered call and a cash backed short put at the same strike. It is no accident that the prices for near-term ATM puts and calls are nearly the same. If you go out in time, call prices are higher, but that is a reflection of the interest rate you could get on the cash you hold to back the put. If you set that interest rate to zero, the theoretical prices of ATM calls and puts are the same. It follows that a cash backed covered straddle with ATM calls and puts is exactly the same as TWO covered calls. This is what you are referring to when you suggest that the appropriate quantity to look at seems to be the following ratio: (Strike of Call - Current Price)/(Current Price - Strike of Put). The higher this ratio, the more aggressive the CSS. The lower this ratio, the more conservative the CSS. Somewhere near 1, the CSS is equivalent to two CCs.. A symmetric covered strangle, where the call is written one strike above ATM and the put is written one strike below ATM reduces the potential gain for most of the price range between the two strikes, but elevates it slightly at the call strike and above, and reduces the loss at the put strike and below. It's as if the gain reduced at the original ATM gets squished out into the high and low prices (how's that for technical <gg>), and the wider you separate the strikes (the higher the ratio you have identified) the more squishing there is. This is where I think one might consider the cash backed covered strangle to be advantageous compared to two CCs. If you are willing to sacrifice gain potential at the ATM price, you can improve upside potential and reduce downside risk. But don't be mislead into thinking the wider the better. What you are giving up by going wider is premium, and carried to an extreme all you are doing is giving away a put that will hurt you in a severe downturn, with no more advantage to the upside than a single OTM CC at the upper strike. The discussion of risk cannot be separated from the assumptions being made about cash backing the position. If you accept that the cash backing the put is part of the investment, every bit as much as the money paid to acquire stock, then the risk-reward profile of the cash back covered strangle is very much the same as a covered call with twice as much underlying and the same total number of written options (two calls vs. a call and a put). If you make the strikes very wide, the cash backing the put gets very small, and the whole thing reverts to about the same as writing a single CC at the upper strike, except that if the stock falls below the put strike you lose more. So if you are thinking in terms of making a CC more rewarding by selling puts to capture more premium, and not recognizing the cash that you may have to pay if and when assigned the put as part of that investment, then the price for that extra gain is an approximate doubling of the downside risk for a strangle of moderate width. You just have to make sure you are comparing the right things. If you are accustomed to writing pretty far OTM calls for relatively small premiums, and contemplate writing a far OTM put for a few extra cents, be very sure the stock is not going below the put strike. I can't find a way to justify that risk. Dan

To: Mathemagician who wrote (1937)	8/15/2001 10:07:48 PM
From: BDR	Respond to of 5205

<<The maximum loss associated with a covered short strangle is Current Price + Strike of Put - Premium of Put - Premium of Call. That is not unlimited loss.>> Thanks for walking us through the numbers. It clarifies the position a lot better to have a concrete example. I would agree that actually the loss is not unlimited. It is not infinite, but a finite number, as you indicated, determined by the stock and strike price reduced by the premiums received. In the unlikely event that the stock went to zero the loss would be all of your capital at risk. To someone in that situation the difference between unlimited and finite may seem academic but your point is well taken. I think the main point though should be that the position (covered call plus short put) caps gains but doesn't cap losses.