Covered calls on AAPL? Not!

My friend is all exited because of the money she made with the recent jump in AAPL. Just a few weeks back she explained to me that she had a large position in stock and that she had sold calls against it. I told her that a covered call is really not a smart way to trade options because you have all of the risk of owning stock and not much of the reward, if the stock rallies strongly. The idea in a covered call is to sell premium in a call that you believe is expensive. However, you must protect yourself against an huge jump in the stock by either buying a call at a higher strike price, or owning the stock itself.

I was talking in one of my webinars about “Synthetics”. That is, for every option position, there is a stock and option combination that matches it well on risk and potential reward. To easily understand the synthetics, you need to calculate the stock as having the potential reward of a long call and the risk of a short put. In essence:

Stock = long call + short put

So, a covered call is the same as:

Stock + short call = long call + short put + short call :.
Stock + short call = short put.

When you look at it that way, then you have two possible substitutes the covered call, which requires much cash to keep in your account:

You can simply sell a put. However, you should not sell more puts than the equivalent stock position that would result from assignment. Here your broker is going to request that you keep enough cash as though you were to buy the stock. Here again, you have much capital at play, and at risk, just to get the “premium” of the short put. The sad part about this is that when a stock rallies strongly, and all you have is a short put, it makes no difference how high the stock goes, as long as the put expires, your reward is always the same.

The covered call is not much different. If the stock rallies strongly, you do not have a better reward than if the stock has just gone high enough to call away your shares. Perhaps you are happy with this, but given the cash at risk in a covered call, you must realize that the risk/reward ratio is rather high. If you really think that the stock will go slightly higher at a slow rate, but you are concerned about an unexpected decline in the stock price, perhaps you want to enter a Collar. In essence, with the collar, all you did is use the proceeds of your short call to buy a put. This is used if for some reason you do not wish to exit your stock.

Covered call = stock + short call
Collar = stock + short call + long put.

This again is not a very practical approach because you have much capital at play, that you insist in protecting by buying the put. Yet, you have limited your potential to profit, should the stock jump strongly. Here again, this is not the kind of trade that you would do if you want to protect your capital. Now, what if we use our knowledge of synthetics to create a position that is equivalent to the collar, but does not require so much capital?

The call vertical spread is the synthetic equivalent of the Collar, and can be used when we believe that the stock is going to move slightly higher over a long period of time, say 3 months to 1-2 years.

long call + short call (higher strike price)

Why is this equivalent to the collar?

Collar = stock + short call + long put

remember, the stock is equivalent to a long call + a short put, so our collar becomes

so the collar would be the same as a vertical spread, as long as the short call is above the current price. Try drawing a risk graph for the collar and the call vertical spread and you see that this is the same.

I don’t know if it was due to my influence or not, but the fact is that she bought calls on AAPL, before the post-earning jump. Perhaps my webinar made it see the light. Now would my friend be so happy as she is if she had vertical spreads, collars or covered calls? probably not, although she would be satisfied that the stock went up, perhaps she would be sad that this stock has been called away. So what made the different for her?

I would rather own one long call of a momentum stock than 1000 shares of stock with 10 short calls on top. Why? because the long call has unlimited upside potential but only limited downside risk. In essence, you can have the cake and eat it too, so long as you do not risk all of your capital on a few calls. Don’t go buying enough calls to meet the cash you were willing to use in 1000 shares of stock, you should think of the calls as equivalents of the shares of stock you are willing to buy, or perhaps a little more, but always contemplate how much you’d lose if the stock trade goes against you and falls below (or does not reach) the break even point by expiration.

The important thing to remember about long call options is that they are going to be expensive during a raging bull market, specially when the underlying is a “high flier”. Sometimes, however, the price is justified, if the stock is capable of jumping >10% in one day or >30% in one week. Not many do that this days, but AAPL and AMZN come to mind.

Back in the 90’s I had a friend that call me regularly for my opinion in her idea to buy technology stocks such as CSCO or SUNW for example. She had a knack for picking them at the top. I would say, don’t buy stocks, buy the long call... She would reply, stock is what I know. Eventually playing this game she was burned when the market reversed. I got burned too, but because I was buying calls, my loss was minimal. The value of limiting your risk was obvious to me. Clearly, I thought, there must be a combination of options that would allow me to own a position that has limited risk and unlimited reward but that would not require the attention that a long call would require.

My two friends learned, I presume, that holding stocks is capital at risk but the gains you accumulate are in danger if you hold overnight. I should know, I was holding AAPL back in Sept 2000, when it collapsed overnight from $63 to $28. I am lucky I did not hold Enron. There are approaches to trading stocks that limit risk and maximize reward and lower the break even point to near the current stock price (or raises it in the bearish case). This is what my Tuesday’s webinars are all about.

Yes, I do have 3 webinars a week, that is attended by the participants of my group. Would you like to participate? you can join the group and then subscribe to the webinars for a year. I ask for a small contribution to keep the effort going, pay for my expenses and not much else. Please send me an e-mail at paperprofit1@mac.com and I will tell you how to enter in the group and what you’d get.