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Actually I think both of you are making valid points. To Howard's point, the covered call is conservative if you look at it in terms of just the option part of the transaction. To user's point, the entire transaction should not be viewed as conservative because there's nothing protecting the downside risk of the underlying shares. (except for the small premium from selling the call)
It seems like the key to making money with options is make sure you don't put the cart before the horse. By that I mean I need to research the stock first and then come up with a options strategy around that stock research. It's tempting to just say I'm going to try a put spread and then go looking for a stock that might fit that strategy. That seems like the wrong way to do it.
I'm going to try to be patient until I find a trade I am comfortable with. Thanks for the info in the thread.
Actually I think both of you are making valid points. To Howard's point, the covered call is conservative if you look at it in terms of just the option part of the transaction. To user's point, the entire transaction should not be viewed as conservative because there's nothing protecting the downside risk of the underlying shares. (except for the small premium from selling the call)
Yes, but why would it make sense to just look at the option part of the transaction? The two transactions are married, by definition, so you can't really isolate one from the other. When people talk about covered calls being conservative I think they have the following conditional in mind:
If you already own XYZ long then selling covered calls against it is a conservative option play.
But I don't even think this is right. A covered call dramatically limits the upside while only provide small downside protect. Doesn't this change the overall risk/reward profile?
Actually I think both of you are making valid points. To Howard's point, the covered call is conservative if you look at it in terms of just the option part of the transaction. To user's point, the entire transaction should not be viewed as conservative because there's nothing protecting the downside risk of the underlying shares. (except for the small premium from selling the call)
There's nothing protecting any stock, whether bought long, or sold short. There is nothing to protect an option collar.
What protects the downside on a stock, or the risk, is the price at which you bought it.
I know someone who bought 1000 shares of a stock after it had risen 80% in two weeks. Bad timing. He's sitting on a 50% loss now. He bought at a very bad time.
What makes the covered call option conservative, is what stock, and when you buy it. Example. You like IBM. The stock was $185.00 before their earnings. The numbers were good and over the next few weeks it rose to $200.00. The market corrects and IBM goes back to the middle or low 180's. THAT is a perfect spot to buy IBM and sell a $185 or $190 covered call. You are doing it at a price that you have determined to be, based on all your rersearch, near a "trading bottom."
A bad spot to sell a covered call on IBM might be after it went from $185 to $200. You're buying at what might be a "trading top."
It all depends on the stock.
Some covered calls on very volatile stocks can let you sell a covered call and make money even if the stock goes down.
Last month an option idea was suggested on Humane Genome Sciences.
Buy the stock and sell a "deep in the money covered call." Profit would have been 7% in 90 days. This 7% profit would still be there, even if the stock had fallen 30% to $7.05.
So, make 7% even if the stock falls 30%.
Some people migght laugh at only 7% in 3 months, but the point was, you can use covered calls to make income even when the underlying stock declines.
Yes stocks can go down, but options sold can be bought back and the stock sold. Another idea is buy a stock, sell a covered call, and buy a put option to protect the stock, in case of a decline in the stock.
When I use covered calls, I use them on stocks I am comfortable holding long term. And I buy in at the bottom of a channel, or trading range. If it breaks out the bottom, I become a longer term holder and I knew that before I bought it. Other people may control the markets, but I do not.
Any stock can go down.
There's nothing protecting any stock, whether bought long, or sold short. There is nothing to protect an option collar.
What are you even trying to say? There is nothing protecting a long position in itself? Sure...and that is precisely why they involve a lot of risk. Or are you trying to say that there is nothing you can do to protect a long position? That, of course, is fundamentally wrong.
There is nothing protecting an option collar? What does that even mean? A collar will have a defined max loss which will be a small fraction of the initial capital outlay.
Quote:
Originally Posted by howard555
What protects the downside on a stock, or the risk, is the price at which you bought it.
Unless you bought it for zero dollars then no, this is just an absurd suggestion. Buying a stock for what appears to on technical, fundamental or whatever other voodoo you're using grounds doesn't protect your downside risk.
Talking about a covered call "making money" when the underlying security has lost more value than the revenue generated by the call makes little sense. I mean, if you give me $1 and I return $.70 but then give you an additional $.07...have you gained anything?
Quote:
Originally Posted by howard555
Another idea is buy a stock, sell a covered call, and buy a put option to protect the stock, in case of a decline in the stock.
Other idea? What you're describing here is known as an option collar..... A strategy, unlike just selling covered calls, that is conservative because it protects your downside.
Just an aside, but the "risk" of any transaction has at least two basic components -- magnitude and frequency.
Of course going long a stock carries the risk of a 100% loss; however, the probability of that happening is generally very low. Because options tend to add leverage to a transaction, small fluctuations can produce very large losses, and small fluctuations are generally much more likely than huge fluctuations.
Consider two arbitrary transactions: Trade A has a 1% chance of a 100% loss and Trade B has a 75% chance of a 75% loss. Even though Trade A offers the possibility of a much larger loss, Trade B is definitely more risky. And that can be an abstract concept, but the easiest way to understand it is that if you executed each trade 1000 times, the more risky strategy - Trade B - would produce a bigger total loss.
To implement such a risk management evaluation, you would need to know the probabilities of every possible outcome (i.e. 1% chance of a 10% loss, 5% chance of a 20% loss, 10% chance of a 50% loss, and so on), which would be used to calculate the expected value of each strategy. And those probabilities are going to continuously change as information hits the market, so it's not really possible to quantitatively consider that type of analysis (High Frequency Trading shops can, though). But the principle also has qualitative value, and it explains how trades with a low frequency of a large loss can be less risky than trades with a high frequency of a small loss.
It's not possible to determine if one option strategy is more or less risky than another by looking only at the size of the possible losses; you also need to know the frequency each possible outcome.
Any long or short, stock or option, can lose 100%.
So to say that, as a 100% guarantee, is 100% wrong.
Meaning, if you can not handle the risk of any such investments, then stay in your funds, CD's, and other things that you might consider as having 0 risk.
Because options tend to add leverage to a transaction, small fluctuations can produce very large losses, and small fluctuations are generally much more likely than huge fluctuations.
Most options trades aren't of this character....
Quote:
Originally Posted by ML North
Consider two arbitrary transactions: Trade A has a 1% chance of a 100% loss and Trade B has a 75% chance of a 75% loss. Even though Trade A offers the possibility of a much larger loss, Trade B is definitely more risky.
There is nothing definite about this...you are not specifying enough information to know which is more risky. You'd have to know the entire probability distribution.
Quote:
Originally Posted by ML North
It's not possible to determine if one option strategy is more or less risky than another by looking only at the size of the possible losses.
You don't say? This had nothing to do with my point which was that a covered call is hardly a "conservative" option play because it does nothing to protect your downside. 100% loss is just the extreme case, but there are no equities that don't suffer from significant downside risks. On the other hand a collar provides significant downside protection while only reducing your upside by a small amount in comparison to a covered call play. If you think of both plays in terms of the same underlying equity then the collar is clearly less risky than the covered call. Of course that assumes you don't have god like powers to know the underlying probability distributions of a non-linear system!
But investors don't get to know the probability distribution for the potential losses on some equity so this is just claptrap to begin with. The magnitude of the loss or gain is something that is easily calculated, where as the probability distribution is impossible to know. If one could know the probability distribution of potential losses/gains on equities then investing would be a simple matter of maximizing your expected value**.
But yes, obviously magnitude in itself doesn't tell you everything you need to know. But its the only value you can actually know....
**I see you mentioned this above, so then you seem to think that the probabilities are actually knowable? Not sure how you imagine that works....tea leafs?
Last edited by user_id; 02-13-2012 at 01:59 PM..
Reason: additional note
Any long or short, stock or option, can lose 100%.
Yes indeed, but one of the main reasons for using options is to offset, in part or in total, the potential loss of another security. So of course a put option and a share of common stock can each possibly lose 100% of their value, but it aggregate the goal is to reduce to total risk of the entire position -- both the "magnitude" component and the "frequency" component.
Quote:
Originally Posted by howard555
So to say that, as a 100% guarantee, is 100% wrong.
I'm not entirely sure what you're getting at here.
Quote:
Originally Posted by howard555
Meaning, if you can not handle the risk of any such investments, then stay in your funds, CD's, and other things that you might consider as having 0 risk.
Nothing has zero risk and no one should be lead to believe otherwise. But, every options strategy on every security has a slightly different risk profile, and even though it's only possible to consider that risk profile with a limited degree of certainty, it's none the less a worthwhile exercise.
Any long position exposes you to significant losses.
That must be your opinion. It is clearly not a fact.
Maybe a poll needs to be taken.
A long position with a put option for protection, and covered calls with it, is no more risky than a spread collar.
And with options you have to be:
1. 100% right on the direction and
2. 100% right on the timing.
Or you lose 100% of both legs = high risk for in-experienced investors.
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A strategy, unlike just selling covered calls, that is conservative because it protects your downside.
