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Should covered calls always be done?

Chris McKhann (chris.mckhann@optionmonster.com)

Selling calls while holding stock is the most popular option strategy, and a potentially profitable one at that. So the question arises whether one should do it all the time against all holdings.

Primary reasons for the popularity of this trade, known as a covered call , are that it has better returns and lower volatility than simply owning stocks. Covered calls will outperform equities alone in all but the most bullish market environments.

This is because the premium taken from selling calls against stock provides a cushion if the stock falls and generates income in sideways markets. If the share price rises too far, however, you will have to sell your stock after the maximum gain in the strategy has been realized.

The benefits of the covered call strategy--or a "buy/write," as it is sometimes called--can be seen in the eponymous CBOE BuyWrite Index (:BXM). The index, which tracks calls that are sold against the S&P 500, has had better returns and lower volatility than the index itself in the long term. Studies have shown that using the strategy against individual stocks has similar results, which makes sense given its risk characteristics.

So does selling calls against long stock always makes sense? The answer depends on your outlook for the given equity.

If you think that a stock is going to fall, then a covered call will perform better than just owning the stock, if only by a bit. If you are wildly bullish on a stock, then you are better off not selling the calls, which limit the upside potential.

Given these parameters, the covered call is often used by those who think that the stock will be range-bound or if you are only mildly bullish.

But there are potentially better strategies if that is your outlook. The primary one is put selling . I have discussed in a number of places the fact that put selling tends to be superior to covered-call selling. 

Underscoring this point, the CBOE PutWrite Index (:PUT) has even better returns and even less risk than the BXM. From June of 1988 to the end of 2011, the S&P 500 had a return of 9.1 percent and a standard deviation of 15 percent. The BXM had a return of 9.4 percent and standard deviation of 10.7 percent. The PUT had a return of 10.8 percent and standard deviation of 10.2 percent.

If you are in a situation where you have to own stocks, you are likely best served by selling calls against your holdings in most circumstances (one being when stocks are extremely oversold and the VIX is elevated). But selling puts is likely a better strategy.

It is interesting to note that there are a handful of new funds out there that are based on the premise of the covered call, but there are very few that are based on selling puts. I believe that this is due to the popular perception that put selling is somehow more risky .

Such funds often sell to clients who are less educated in the markets, so they tend to peddle more "palatable" products. But as individual traders and investors, we need to be sold on only one thing: strategies with better returns and lower risk.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Feb. 20.)