I recently opened an account with Mr. Stock and found the following fable under the section on education. I thought it might be helpful for those contemplating CCs:
Emperor's Covered Write
An Options Fable
Once upon a time, there was a vain young emperor who liked fancy clothes, golf and trading options. The emperor thought of himself as a prudent man and therefore readily accepted the advice of his broker that he should hedge his stocks by selling calls. These positions he called "covered writes." His loyal subjects showered him with praise for his financial wisdom and fiscal prudence.
Then one day an unfortunate event occurred. The stock market dropped, and all of the emperor's beloved stocks went down - a lot. Despite the severity of this market move, the emperor felt happy that he had hedged. While there was panic throughout the land and while his loyal subjects lost much of their meager holdings, the emperor sat in his counting room, secure in the knowledge of his own imperial foresight.
Unbeknownst to the leader of the land, at the entrance to the huge castle, a messenger strolled into the main courtyard. He handed a message to a castle guard, who in turn gave the message to the court advisor. The advisor and royal servants mulled over the message, and finally decided to draw straws to decide who should deliver the message to the emperor. The newest servant, a young man named Dave, drew the short straw.
New to royal servitude, Dave solemnly accepted his duty. He took the message, drew a deep breath, and began to climb the long staircase to the royal counting room. With him, he carried what the emperor never expected to see: it was a margin call.
Absorbed in reviewing his regal wardrobe, the royal leader did not expect an interruption by the lowly plebe. Dave entered the room and, in his best official voice said "Oh great emperor, I must tell you that your stocks have dropped to near zero, you have lost most of your money and you have a margin call."
The emperor was annoyed. "I cannot have lost money, for I hedged by selling calls. Off with your head."
Bravely, Dave explained: "Well sire, the selling of calls against your stocks merely limited any potential profit; it did little to protect against a major drop in stock prices. The few dollars that you collected from selling calls were a mere pittance compared to the amount that your stocks have dropped. I'm sorry to say your majesty, that for the past few years, your stock market position has been the equivalent of being short naked puts."
"Are you calling me a fool?" snapped the angry leader. "No sire," said Dave. "Your covered writes are popular strategies and certainly can have some appropriate uses in a portfolio. However, they are a poor hedge against rapidly declining stock prices."
The boss hesitated; he had been caught naked before and did not intend to repeat that embarrassment. Despite his instinct to summon the executioner, he said "Tell me more young man. What do you know about covered writes and this thing you call 'naked puts?'"
Dave was nervous. After the invisible robe incident, heads had rolled. Employee moral around the castle was never quite the same. Dave wondered if a basic option lesson might help. "Sire, if I may, I shall explain the entire theory of equity derivatives."
Despite his flair for fashion, the emperor was a practical man. "Theory schmery," he said. "If I want theory I'll ask the Wizard. I need practical advice and I need it now."
Dave stood at attention. He knew he had better get to the point. "Yes your highness. A covered write has the identical risk profile of a short uncovered put. In both cases you earn a small amount if the stock goes up, but lose a large amount if the stock goes down. This is similar to selling fire insurance. You would never insure just one house against fire. The insurance business works because underwriters insure tens of thousands of houses against fire, and collect premiums that are high enough to offset their expected losses. When you do covered writes, you become an underwriter, not an investor."
"But covered writes are so popular," the emperor noted. Dave continued, "Yes they are; but I believe that they are an over-used strategy. If you buy speculative stocks that you expect to rise dramatically, you should also expect that some of these stocks might drop; in a crash they might all drop. As a long-term investor, you should not sell calls against your most volatile stocks. In fact, if you are concerned about anything, it should be the downside risk. You should either buy puts against your stocks or buy calls instead of buying stock. Actually, owning puts and stock is the identical profile to owning calls, except that straight calls offer more leverage since they usually require less cash up front."
"I still have a question," said the emperor. "Why would anyone buy a covered write?" Dave said "When you are certain that a stock will stay in a narrow price range, you can earn an enhanced return by buying stock and selling calls or by selling calls against stock you already own. The trick is that if you are wrong and the stock price makes a big move up or down, you must be willing to accept big losses or accept having your stock called away. There is a great temptation to earn an enhanced yield by selling calls, but this is often a mistake. Bottom line is that covered writes are a bet against stocks moving down. If they move down, you lose."
The emperor was silent for a moment, then said, "Thank you young man, you are dismissed." Dave bowed. The emperor turned toward the guard standing by the counting room door and said, "Bring me my stockbroker."
Moral: Make sure you know all the risks involved before implementing any option strategy.
Trading options involves risks and is not suitable for everyone.
Please review the OCC document entitled Characteristics and Risks of Standardized Options. |
