May 29, 2002

In an earlier column, we discussed the advantages of using a covered call writing strategy.  Last time we began our discussion of what can go wrong when using that strategy.  We now continue the discussion.

4) When you use a call option to sell stock at a price higher than the current price, you are improving your chances to make such a sale.  However, there is a risk that is not immediately apparent. 

Let’s say your goal is to sell stock, currently priced at 40, for 46.   If you sell a call option with a strike price of 40 for a premium of 6, you will achieve your goal (sell for 46) if the stock is above 40 when the option expires. (You will be assigned on the call, selling the stock for 40.  You add the proceeds from that sale to the 6 you get for selling the option now, giving you a total of 46, your target price.)

The other way to sell stock for 46 is to call your broker and enter a good ‘til cancelled (GTC) order.  Although I believe the call option method has a better chance to succeed, there is a risk involved.  If you enter a GTC order, you will sell the stock if it trades at your price, or higher.  If you use the call option method, you must hold the stock in your portfolio, and cannot sell it during the lifetime of the option.  (You must maintain ownership of the stock, so that you can deliver (sell) it to the option owner, if and when he decides to exercise his rights to buy your stock for the strike price of 40.  If you sell the stock, your position consists only of the short call option, and that position is far too risky.  Even if you want to hold that position, your broker probably does not allow it.)   If the stock trades as high as 46, you will not be able to sell it.  If the stock then turns lower, and is below 40 when option expiration arrives, you not only will have missed selling the stock for 46, but you also will not be able to sell it for 40 on expiration day.  That is because the option owner will not exercise the call, but instead, will allow it to expire worthless.  You have gained the $600 you collected for selling the call option, but you have not yet achieved your goal of selling the stock for 46.  Once the option has expired, you are free to sell another option and collect another premium.  It may turn out that you sell the stock for much more than 46 (because of the extra premium you are collecting), but for now, your goal has not been achieved.

The risk is that you may lose the sale of your stock for your target price.  It requires an unlikely combination of events for this to happen, but it is possible, and if you adopt the call writing strategy in an attempt to sell your stock for a higher price, you should be aware of the possibility.

5) If you use the call option method to buy stock for a lower (than current) price, you will achieve your price target, but for the lifetime of the option, your potential gain is limited (you may have to sell the stock, for a nice profit, to the owner of the call option).

Another way to buy the stock for your target price is to enter a GTC with your broker and hope the stock price drops to your price level.  If you are lucky enough to get the stock for your price, you will be better off because there will be no limit to your potential selling price.  There is a good chance the stock does not drop in price, and you will be unable to buy it for your target price.

You must choose between entering a bid and hoping things work out well for you, or choosing the option method.  The covered call method allows you to buy the stock – but in return, your potential profit is limited.  I believe it is a very good strategy to use the option method and accept the limited profit.  If you do not use the option method you may never buy the stock, so instead of the limited profit you may have no profit at all.

Using call options in an attempt to buy stock for a price significantly lower than the current market price, or to sell stock for a price significantly higher than the current market price represent two of the most intelligent ways in which call options can be used.  Today’s discussion merely points out the strategies are not perfect, but I recommend them highly.

In summary, the risks involved with the call writing strategy are minimal, when compared with the potential gains.  If you are a buy and hold investor, you should seriously consider whether or not this strategy is appropriate for you.

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