Trading Idea

Covered Call Horror Stories

Richard Croft
September 13, 2016
5 minutes read
Covered Call Horror Stories

In the late 1990s I sold a covered call on, let’s call the security, XYZ. A “nom de plume” to protect the guilty… or innocent, depending on your point of view.

In any event, XYZ was a particularly volatile technology company trading at $21.75 per share in January 1998. I bought the shares for myself and clients and immediately sold January (1999) 22.50 calls at $4.75 per share. Looked pretty good when I entered the trade. The one year return assuming XYZ was called away, came in at 32.3%.

A much better return than the TSX composite index with significantly less risk as it turned out. To be fair, I need to qualify what I mean by less risk. Investors do not view risk in terms of volatility but rather focus on downside risk which equates to the likelihood of losing part or all of one’s initial investment. At least initially!

By the summer of 1998, XYZ was trading in the high 60s. The risk of loss at this price point is virtually eliminated and that triggers an interesting transformation. With risk off the table the focus shifts to performance or the lack thereof.

As a portfolio manager I had positioned myself and clients into a stock that beat the market, did so with less risk, and yet by the end of 1998, the most frequent comment I heard was; “I wish we hadn’t sold calls on XYZ!” I can’t tell you how many times clients looked at their accounts and saw the performance of XYZ, only to see an offsetting position in the XYZ calls. And perhaps, in hindsight, they were right. Maybe it was a mistake to have sold the calls on XYZ. And there lies the rub!

That’s risk with covered call writing is that you end up losing the best performing stocks in your portfolio. Sometimes at a fraction of the underlying securities market value when the options are exercised. By January 1999, XYZ was trading at $83 per share only to be called away at $22.50. Brought tears to my eyes!

The XYZ example, however painful, provides us with three basic principles; 1) never forget the reasons for selling the option in the first place, 2) always recognize that a covered call writing can and often does, eliminate the best performing stocks in your portfolio and 3) ask yourself, if there are follow up strategies that could enhance the returns from the original position.

As for a follow up strategy bear in mind that we are not looking to repair a losing position but rather, are looking for ways to enhance the performance metrics when the underlying security breaks through the strike price of the short call.

To that point the most common follow up strategy is the bull put spread. A bull put spread involves the sale of a put with a higher strike price, and the purchase of a put with a lower strike price. The position is established with a net credit, and does require margin. Assuming the initial covered call write was paid for in full, you may not be required to post additional capital in order to implement the bull put spread.

In the XYZ example, when the shares were in the mid-30s I could have executed an XYZ January (1999) 40 – 30 bull put spread. Most likely the spread would have generated $3.50 per share net credit which, in hindsight, would have doubled the performance.

But I suspect from years in the trenches, it would not have been enough to placate clients who simply felt violated having to sell their shares at 25% of the value they were trading at in January 1999.

Richard Croft
Richard Croft

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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