Beware of risk factors in covered calls

optionMONSTER

The covered call is the most popular option strategy and is usually the first one tried by new traders. Many brokers have covered calls as their "first level" for clients, as it is in many respects a natural progression from owning stock.

A covered call involves selling calls against stock you own, 1 contract for every 100 shares. So if you own 100 shares of the SPDR S&P 500 Fund (SPY), you might sell 1 June SPY call that expires in 30 days. Most traders use slightly out-of-the-money calls. So if the SPY runs back up to levels around 168, you might sell the 170 calls for $1.40.

This position is, for the most part, less risky than just owning shares of the SPY. If they are unchanged, you make $1.40 in the next month for about a 0.8 percent return in that time. It also means that the covered call position doesn't face losses as long as the SPY is above $166.60 at expiration, given the credit for the sold calls. Owning shares would have been a better strategy only if the SPY is above $171.40 at expiration.

So what are the downsides? Some are technical. If the SPY is above that 170 strike you sold, you face assignment and the obligation to sell your shares, which you may not want to do. If the stock starts tanking and you want to get out, you have to buy back the calls before you can do that. For that reason, you can't use stop-loss orders.

But the real reason I don't like covered calls right now is because of expectations. The actual volatility in the market is quite low, and the volatility expectations are higher, but not by much. Volatility data can get quite confusing, but it is a very useful way of looking at option prices.

In the SPY, for example, the 20-day historical volatility is 8 percent. That gives us a measure of the actual recent volatility of the stock, and it is just above 52-week lows. It was twice as high a month ago.

The volatility expectation priced into those calls is 12 percent. That is clearly higher than the actual volatility, but it's pretty normal. And that number too is near lows--which is key.

The covered call is a strategy that you typically use when you expect lower or continued low volatility. But I believe that we could see a wave of volatility in the near future, so I am hesitant. The rise in intraday volatility and in the VIX, even as the SPX goes higher, both point toward that conclusion.

So if you own stock and plan on holding onto it, then I think selling calls against those shares at this point makes good sense. It provides some upside potential and some downside cushion.

If you are more concerned about the downside, you could use some of the proceeds to buy puts to protect the position. That overall strategy, known as a collar , limits the downside risk through the ownership of the puts but also curbs the upside potential through the short calls.

For those who are looking for trades, I would not be short volatility here. Instead, I would be overall a buyer of calls and/or puts.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter of May 22.)

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