Yes, Virginia, There Are Risks Involved

September 16, 2008
Mark D.Wolfinger

Physician's Money Digest, March15 2003, Volume 10, Issue 5

Sometimes, even the best things in life havea downside. Take chocolate, for instance.Sure, it's a satisfying sweet treat, but ifyou ate it every day, there's a good chance yourbody would eventually suffer. Besides weightgain, your blood sugar levels would increase dramatically,which would increase yourchances of developing diabetes. Soeven a good thing can be a bad thingsometimes.

But what does chocolate have todo with market strategy? The answerto that question—not much. However,by illustrating the fact that evensomething dearly loved has a bad sideas well as a good, it is my hope thatyou'll be more accepting of the factthat even good investment strategieshave their bad qualities. And so, justlike chocolate, covered-call writingisn't always perfect.

LEADING THE RISK LIST

The major risk of a covered-callwriting strategy is that your profits arelimited. When you sell someone theright to purchase your stock at a specificprice (ie, strike price), you're unable to sellthe stock for a higher price. So, if perchance thestock makes a significant rally, you're out of luck.Eventually, the option owner will exercise theirright and buy your stock for the agreed price.When this happens, you wind up making lessmoney than you would have made by simplyholding the stock.

If this happens, however, you shouldn't beupset. Remember, you sold the option to obtaininsurance against a decline in theprice of the stock. You also sold theoption to increase your chances ofearning a profit. And you did earn aprofit: the money from selling the calloption. The investor who bought youroption is entitled to make moneysometimes. Think about it: If optionbuyers never made money, therewould be no one to buy your optionswhen you wanted to sell.

FOLLOWING CLOSE BEHIND

Another drawback to the covered-callwriting strategy is that you mayactually lose the opportunity to sell thestock. For example, let's say your goalis to sell the "chosen" stock for $46.You have 2 options: call your brokerand enter a good-till-cancelled orderto sell the stock if and when it reaches$46 (the traditional way), or sell an option for $6now and hope to get $40 for the stock later,when you are assigned the call option (this givesyou a total selling price of $46).

So, where does the risk come in? With thecovered-call strategy, you must hold the stockfor possible delivery to the option owner and areunable to sell it when the price is $46. If thestock reverses direction and is below $40 onexpiration day, the stock won't sell and theoption will expire worthless. Sure, you have$600, but you still own a deflating stock. You'llthen be in the position to sell another calloption, collect another premium, or sell thestock, but if the stock is significantly below $40,it's going to be a difficult sell.

Au contraire:

In addition to this risk, if the stock pays a dividend,there's a chance you could lose the dividend.The owner of the option has the right to exercisethe option and buy your stock anytime before theoption expires. And they may choose to exercise itand claim immediate ownership of the stock theday before the stock goes ex-dividend. No bigdeal? To collect the dividend, youmust own it on exdividend day. The buy-and-holdinvestor always receives the dividend.

Although there are times when it doesn't producethe best results, a covered-call writing strategydoes offer investors a great opportunity.Compared to a buy-and-hold strategy, it makesmoney more often and loses money less often.And despite the risks involved, it may be a goodoption for you during these uncertain markets. Itmay not be as sweet as chocolate, but it's anoption worth considering.

Mark D. Wolfinger,

author of The Short

Book on Options: A Conservative

Strategy for the

Buy and Hold Investor, is

an educator of public

investors. He was a professional

options trader

at the Chicago Board

Options Exchange for

over 20 years. He welcomes

questions or

comments at mark@mdwoptions.com. For

more information visit

www.mdwoptions.com.