Investors Need to Think Carefully About Selling Call Options

Call Options

All it takes to attract the interest of a lot of older investors is to use the word income with an investment. This is a foolish bias that can cost them though.

The strategy of selling covered calls is widely promoted, especially to older investors who find the fact that this is framed as a way for them to make income. It’s all income though, and if we hold a bias toward certain types of investments like this, we need to be sure to think about what we are doing enough and especially weigh the opportunity costs of our strategies.

They do make this particular strategy sound so sweet to a lot of investors. You own the stock anyway, and you can sell your interest in them over a certain level for a price. If your stock doesn’t go up enough, you pocket the premium, the money they gave you to sell this higher interest. If It does go up past your strike price, you keep the premium but give up profits to the call buyer beyond it.

A great many investors out there happen to be so easily persuaded that they can be talked into pretty much anything if we just call the returns that they get income, anything from very low returning bonds to the worst stocks in the market provided that they pay a good dividend, even though we would think that the mistakes that these strategies make should be so obvious. The mistakes with selling call options require us to do a little more thinking than this to discover, but we must think enough about what we do with our investments if we even want to pretend to be diligent enough.

A lot of people who recommend options, including both advisors and self-proclaimed experts who recommend them through articles, don’t really have the depth of understanding of options to even be in a position to recommend them, although these things don’t usually serve as much of an impediment. If you are blind, you won’t know if the person leading you is blind as well.

There are some who at least preach caution with investors selling call options. Steve Sosnick of Interactive brokers at least is trying to get people to understand the risks of this, and describes the risk here as missing out on the right to further gains above your stock price.

Risk doesn’t always mean risk of losing money, as it also applies to the risk of losing opportunities, and this is a clear case of that. This is not to say that this risk can’t be managed, and it definitely can by a skilled and experienced options trader, who won’t stick around for long if things don’t go well and will trim their opportunity cost losses with these trades by closing their options positions.

Putting your average investor or virtually any investor behind the wheel of even the most simple of options trades like writing calls, and they don’t get more simpler than this, is like putting people who can drive a car behind the wheel of an airplane, hoping that their driving skills will transfer over well enough to become a pilot. Such a thing won’t end well.

We always need to be asking what our edge is whenever we enter a trade or investment, especially with a trade, and options trading isn’t called trading for nothing. If you have no idea what you are doing and are just doing this because it looks like a cool idea and you’ve read about other investors making money from this, you have no edge and in fact you are the edge for the skilled traders who will be more than happy to take your money on balance.

How this works is that you sell your interest in your stocks beyond a certain point for a price. Let’s say the price is currently at $100 and you sell calls at $110. You collect a little money from doing this, where if the price goes above $110, you will sell the number of shares in the contract to the call buyer for $110, let’s say 100 shares, which is the standard contract size.

If the price stays below the strike price, the option expires worthless, and you just keep the premium. This can be packaged to look like a sweet deal for investors whose mouths are open and ready to gobble any worm that comes along, and not notice the hook attached, and there is a hook on the end of this.

The premium is priced at a level which is as close as the market can come to a zero-sum bet, where the less likely an option is to strike, the more you will get for it, and the more potential it has, the higher the premium, to try to get this to the point where there are no winners or losers and only the broker and the more skilled traders make money, taking it from the pockets of less skilled options traders and especially from the amateurs who are the real patsies in this game.

Even though options markets use sophisticated formulas to decide where these premiums are set, that doesn’t mean that they are always right, and sharp traders look to make money by arbitraging imbalances, where they perceive that the market is overpricing or underpricing a premium and end up being right about these things more than they are wrong, with the difference representing their profit.

They actually know how to fly this plane and they are good at it, the ones that do well that is, although for every sharp options trader there is a room full of people who don’t have much of a clue about how to fly a plane but don’t know what they don’t know.

If you sell calls indiscriminately, with no edge or even any real idea of how these things work, at best you are shooting for the zero sum and will actually be prone to take the trades where the balance is against you.

This zero sum doesn’t account for losses past the strike price though, so if you don’t know how to navigate your aircraft you’ll be very prone to continue to hold your positions past the point where you start incurring additional opportunity costs, hoping it will come back to you when the odds are against you and end up making things even worse on balance.

This can be recapped well by pointing out that there is no mathematical advantage to selling calls unless you actually establish one by way of skill, investors don’t have these skills, and therefore don’t stand to benefit at all from the trade over time, and are at very high risk of trading it badly, which ends up to be their loss. When the best you can really do is limit your losses and can’t really profit from these trades in the long run, you need to stop and think a lot more.

Investors Trading Options Do So with Unconscious Incompetence

Neither the investors nor the people advising them don’t understand how options trading really works or they would never consider getting behind the controls of even the simplest of these planes without the right skill and knowledge. They therefore just jump in and fire it up and hope they can keep the thing in the sky once they take off.

Unlike more risky options trades, they at least won’t crash their plane into the side of a mountain, but they will be flying theirs around aimlessly and at best burning fuel which they will have to pay for, and when they get to their destination, they will at best win as much as they lose and be out their fuel bill.

There is not even a good time to be doing this, whether the market is bullish, bearish, or in a sideways pattern. The premiums will be priced accordingly, where once again the goal is to have both sides come out even, where a wager on this will lose as much as it gains overall, plus whatever additional losses occur as a result of mistakes.

Investors do not know a good move from a bad one with options though, they are basically trying to get this plane to fly itself, but autopilot doesn’t work at all with options like they can with stocks or bonds.

This does not stop people from making recommendations based upon their view of how things will proceed, but they don’t know the first thing about flying planes either. Bullish markets are no time to be selling covered calls, and bearish markets are no time to be in stocks period, whether selling calls with them or not. Selling calls risks investors holding their stocks for longer than it may be wise because they want to keep them to cover their options and don’t want to have one out there and be naked.

This is actually a prudent thing, as selling options without the stock to cover you is far riskier, and you are on the hook for the whole move above your strike price instead of being able to cover this with your stock. However, to the extent that this promotes you being stuck in positions due to choosing a lesser evil, choosing evil over good is always a bad idea and adds to the pain of this strategy.

The only sensible move when this happens is to close your option position and run from your stocks, but they aren’t given any instructions on how to land this plane and will have no idea how to manage the trade. That’s just crazy.

Doing this into bullish markets is just too risky, involving greater opportunity cost losses, and in bearish markets, the risk is losing more with your stocks themselves, where the premium you collected will help offset this but you can go a lot further down than that during a pullback.

We might then think that this may be suitable and perhaps even perfect for sideways markets, but premiums during these times are smaller and you still don’t have an edge at all doing it this way, taking on whatever risk is present in both directions and pocketing basically nothing. If you don’t count the risk on both the downside and the upside, and there is risk in both directions, this can make sense, but that’s just trading foolishly, which is always punished.

We should at least speak of what this is supposed to look like when done right, which is quite different than the hands-off approach to them that investors use. This requires very well thought out differentiation between your run of the mill fairly priced options and ones that are favorably priced for speculators, just like when we trade futures and use the hedgers as our dead money, traders that are choosing their trades not based upon an expectation of profit but something else.

If you don’t know who the dead money is, yours is in the pile as well. Strong options traders not only take money from the hedgers, they also make money from investors who are looking to profit from options, unlike the hedgers, but have no idea how to do it and even think that their bad strategy is a good one.

Hedgers drive prices away from the flow of the market, and these opposite forces can create opportunities where they are willing to pay a more than fair value and these are the times that we want to trade with them. Without knowing what to look for and especially without even bothering to look, you won’t find yourself on the good side of things overall.

Trading Options is Far from a No Skill Required Task

People use options to both speculate and to hedge, and if you really know your way around the controls of this plane, you can spot imbalances in options pricing, where the market may be underestimating or overestimating something and you look to capitalize on these things. This takes more than just plopping your behind in the seat and grabbing the yoke though, and to say that this sort of thing is beyond the ability and knowledge of investors is a huge understatement.

While foregoing gains to the upside over a certain amount and basically turning over your shares to someone else, or closing your position to simulate this, does involve opportunity costs, what you would have made on the move if you didn’t sell the options contracts versus what you made with them, we also need to consider other opportunity costs, such as putting your money in something else with more potential.

A simple example of this would be the way that investors cling to their investments when their returns become uncompetitive, for instance with holding an S&P 500 index fund, the SPY, with the intention of writing calls on it month after month but never bothering to check if this is a good thing to have your money in period right now, option selling or not.

This is especially a risk if your investments go down in value, where the probability is on the side of their going down further for a time yet you insist on taking on this negative probability willingly. All they need to do is sell covered calls and they have now placed themselves in a position where they lose if their assets either go up or down significantly, and basically break even over time when they move in a more normal fashion.

Truncating your gains by selling your interest in them but bearing the full weight of pullbacks can also badly mess up the hope of making a good return over time with stocks. Investors settle for chump change that in itself is an illusion, but this leaves them with virtually all of the downside risk without the ability to make up for it.

If they do get slammed, and insisting on selling calls on the way back, they will find themselves dumped off in the ditch and behind most of the move even when we do make it all back. They will still have their premiums in hand but these will be overwhelmed by the amount of their capital losses this strategy failed to recapture on the way back up. This is not a sweet deal, it is madness, making better options traders’ money and getting stuck with the bill.

It doesn’t matter if you sell short-dated or long-dated options, even though people and advisors tend to think that the longer-term options are a better deal. The reason is exactly the same, and the saying that there is no free lunch with options is very true, as the market will price these things in at a zero sum just by its nature, with both sides of the trade battling it out and if there was ever an underlying advantage between buying and selling them, this would become normalized otherwise one or the other side would stop doing it. Sharp traders benefit when they normalize by capturing the arbitrage value, investors trying this will be among those taken by this.

There are two reasons to trade options, to speculate and to hedge, and selling covered calls is purely a speculative move, even though you are speculating that the price won’t go up. This can’t be a hedge because no one wants to hedge against the price going up when you are on the long side of the underlying asset. Betting against the natural upward flow of stocks usually scares investors, like with shorting for instance, but doing this full-time and completely indiscriminately is worthy of being scared of.

Hedging with options involves buying them, to seek to limit your losses, like for instance buying puts below a certain price to cut your losses in your main stock positions. This at least can be used sensibly, although the criticism here is that you are paying a premium for the ability to stay in your positions after they turn too sour, instead of just setting a stop loss with accomplishes the same thing for free.

Unless you are willing to actually learn how to trade options well, you really have no business trading them, and this applies to those who recommend them without knowing what they are doing either. Anyone who actually does know options understand that these positions require skillful management to make money, to know when to hold them and when to fold them in particular, and would therefore be very reluctant to just tell someone to play even their best trades because they would lack the proper know-how as far as how they should be managed, and particularly, when and where to land their planes.

It is so easy to make money from stocks just by holding them as they are going up, and this is not a zero-sum game like options is, it’s one that investors are given such a big advantage that even the most clueless can do very well. You can make a lot more money trading options but only if you really know what you are doing, and the edge here needs to be how much better you are than the crowd, which includes a lot of other sophisticated traders who you are competing with.

If your average investor thinks that they can establish a big enough advantage over the pros such that their profit expectations are higher than with just trading the stocks directly, with a big natural advantage, they are really fooling themselves, and if they even had an idea how much, they would never consider such a thing, at least until they have many hours of proven success with their flying these very complicated aircraft.

For investors who are looking for more excitement, or even something different than being long stocks, there are all sorts of things that you can do to help yourself while at least staying within your skillset. It’s much easier to time markets or pick better performing stocks than it is trading options, especially selling them, which is best left to the experts who make their money on very slight edges multiplied across huge volumes, like market makers with stocks do.

When you sell options, even covered calls, you are really playing the role of market maker, where people want to speculate on the price of something going up and you want to cover their potential gains, and this is a world as far away from the average investor as you could get, bar none. Market makers have to be extremely sharp to succeed, which takes the best instruction and several years of practice to master, not just a tip and a brokerage account with no real instruction and no real idea of what you are doing.

The disease that causes investors to want to do this could be called income-itis, which like all conditions that end in “itis,” are a result of inflammation. This one involves brain inflammation, with the symptoms being confusion over capital gains versus other ways of making money from investments, and thinking that the other ways, called income, is somehow better dollar for dollar.

The disease is even worse than this, as it has us not just discounting capital gains and losses but ignoring them, and all the people who have chosen the “safety” of bank stock dividends in 2020 could tell the story as long as their brains have not become so inflamed that they can look the other way from all the money that they have lost this year on a net basis, or ignore the hideous opportunity costs of low performing investments year after year. There are many though who are this stricken.

If we can pretend well enough that these things don’t matter, if we pretend that underwriting covered options just involves us collecting regular income without any other considerations, such a thing might look good to us. The barkers will always bark, because that is their nature, but our threshold for staking our money needs to be higher than just wanting to join them in the dog pound.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.