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- JANUARY 2, 2010
Covered Calls Prove Popular Strategy
By JEFF D. OPDYKE
Even if the stock market goes sideways in 2010, a number of investors hope to profit through an options strategy known as covered calls.
The strategy works like this: An investor buys a stock, but also sells a call. The call obligates the investor to sell shares to the buyer of the call option at a set price on or before a set date. For this service, the investor typically receives a few dollars a share, immediately pocketing that gain. If the stock rises, the investor potentially shares in part of that upside as well.
Covered calls generate income and can juice returns in any market, though they often make most sense in a market that is flat to mildly bullish.
But investors still could get hammered if stock prices collapse. And the big drop in stock-market volatility means investors are receiving less income for selling calls than they did in the aftermath of the financial crisis, when high volatility pushed options prices way up.
Arthur Feldman and his wife, Laura, look to profit by using covered calls. 'The returns on CDs and money markets and bonds are so low that I'm looking for a way to generate better returns,' he said.
That isn't stopping more people from pursuing the strategy. Overall, stock call-options volume in 2009 surged more than 13% compared with 2008. In December alone, stock call volume was up nearly 30% over last year, and at almost 29 million contracts marked the busiest December since at least 2003, according to Chicago Board Options Exchange data. How much activity is related to covered calls isn't known, but the strategy is so popular that 84% of investors who trade options at Charles Schwab & Co. are using covered calls these days.
Online-brokerage firm optionsXpress Inc., meanwhile, sees "heavy use of covered calls because of the sharp run-up in the market," said David Fisher, the firm's chief executive officer. "A significant number of people think we've gotten all we can out of this stock-market rally, and they're using calls now" to generate income in what many expect will be a flat to slightly down market for 2010.
Selling calls generally works best if stock prices don't move sharply. It is most lucrative when market volatility is high, which results in fatter options prices. Of course, at those moments, like late 2008 and early 2009, the risks are greater, too, because a stock can sink or soar quickly. An investor selling covered calls may be hit with unexpected losses or miss out on big gains. Currently, volatility is near its long-term norm.
Pros like Ron Altman, portfolio manager for the Aston/M.D. Sass Enhanced Equity Fund, use covered calls to pursue stock-like returns but with slightly less risk. Mr. Altman owns what he calls 35 to 40 "high-quality, large-cap stocks" on which he sells calls. In doing so, he generates about 8% annually in options income, and grabs part of the gains when share prices rise. Thus, in an up market, he typically profits less, but in a down market he usually isn't hurt as bad.
"It's awfully attractive relative to reasonable alternatives," Mr. Altman said. His fund is up about 29%, compared with the 24% gain in 2009 for the Standard & Poor's 500-stock index.
Arnold Feldman, an 82-year-old New York City retiree, in mid-December sold calls on the 400 shares of Exxon Mobil Corp. stock he owns. He bought Exxon Mobil at $69.45 and sold the July $75 calls for $2.30 a share. If the energy stock remains below the $75 strike price by the July 17 expiration, Mr. Feldman will keep the $2.30 from selling each call, a return of 3.3%.
If Exxon Mobil rallies, Mr. Feldman will be forced to sell the shares at $75, $5.55 above his purchase price. Including the options income, he will pocket a total of $7.85 a share. Total return: 11.3%. Should Exxon stock move to $80, Mr. Feldman will lose any appreciation above $75.
"The returns on CDs and money markets and bonds are so low that I'm looking for a way to generate better returns and some income" using covered calls, Mr. Feldman said.
His biggest risk: If Exxon sinks, Mr. Feldman faces losses, though the first $2.30 is offset by the call premium he already has received. In 4 p.m. New York Stock Exchange composite trading on Thursday, Exxon's shares closed at $68.19, down 58 cents, or 0.8%.
Selling calls generally makes sense only for investors who don't mind losing the shares they own. If you are bullish about 2010, "then don't sell calls because you'll miss out on a rally," said Jim Bittman, senior instructor at the CBOE's Options Institute.
Covered calls aren't just used by investors who already own shares and want to earn extra income. Many investors use a buy-write strategy in which they buy stock and, in the same transaction, sell call options at a price near the stock's current price and usually expiring in just a month or two. They hope to be called out of the stock quickly in order to snag small gains multiple times a year.
"I used that strategy throughout 2009, when the market was rallying," said Randy Frederick, director of trading and derivatives at Charles Schwab.
There are other concerns with selling covered calls. Investors can lose control on when their shares are sold, and for those with a low cost basis that could trigger large capital-gains taxes. Other investors deeply underwater on shares might be forced to sell at a loss.
Jeffrey Cribbs, a Chicago financial planner, generally discourages clients from using covered calls. Owning stocks, he said, "is about managing downside risk," and investors who sell calls often forget that a stock might crumble. Moreover, he said, with stocks "you're taking equity risk, but because calls can force you out, you're not really getting equity returns. That bothers me."
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