One of the strategies we use in Cabot Options Trader is the covered call. A covered call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income or lower the cost basis on the stock purchase.
This strategy works extremely well in a bull market and in a market that isn’t moving much.
Many traders use a covered call strategy to generate income, buying an underlying stock and selling calls each month in hopes of creating a yield as the option decays.
The strategy is not fool-proof, however. In a bear market, or if you sell calls against the “wrong” stock, this strategy has the potential for losses.
Here’s a look at a stock in which this strategy would not have worked. BlackBerry (BBRY), which used to be named Research in Motion and traded under the ticker RIMM, was a $100 stock at one time.
Had a trader bought RIMM stock and sold calls when the stock was trading at $100 in 2008, it’s most likely the trader would be stuck with a big loss.
For example, let’s assume the trader bought 100 shares of RIMM for $100 a share and sold one January 100 Call for $3. The trader would collect a yield of 3% if the call expired worthless and the stock remained near the trader’s purchase price.
If the stock declined, the trader might simply sell the next month’s call against his stock position. And because he collected the $3 from his call sale, his cost basis would be $97. He might assume that he could do this for as long as it took to become profitable on this trade.
But the trade would not have worked, as RIMM fell consistently for the next five years and is now trading at 9.25. There is virtually no possible way that this trader could sell enough calls to lower his cost basis to 9.25.
I don’t mean to dissuade investors from using covered calls as a way of generating income. In fact, I like the strategy very much in a market that is moving sideways or higher. However, many traders incorrectly assume that they can’t lose using covered calls, and this is simply not the case.