Reviewing the Covered Write (originally posted on 3/28/13)

Probably the most basic, plain vanilla hedging strategy you'll see out there is called the Covered Write. Basically this means owning the stock and selling (writing) out of the money (OTM) calls against it. On the surface this seems a reasonable, prudent and relatively safe way to generate extra revenue on one's stock holdings. Let's say you own AT&T (T) which is currently at 36.60. One can sell the October 39 call at .42. If T never hits 39 the option expires worthless and you keep the premium. If T is above 39 at expiration the stock will be called away and you realize a profit 2.82 or 7.7% (not counting any dividends collected in the meantime). All well and good, right?

Maybe. For one thing, a covered write is a seriously imperfect hedge. The only downside protection you have is the .42 you collected.  With T below 36.18 you lose money. For another thing, you are capping your upside profit potential. With T above 39 your stock will be called away from you.

Fine. I actually think selling calls against an existing stock position can be wise and prudent. Particularly if you bought the stock at a lower price and implied volatility is high (meaning the calls are pricier)

What really bugs me, though, is when so called conservative investment advisors or banks recommend what they call a "buy write", meaning buy the stock and immediately sell a call. This bothers me because what they don't say is that this strategy is in every single profit vs loss calculation possible, exactly the same as selling an uncovered put!! Moreover, just selling the put is one transaction instead of two, thereby saving commissions and it ties up less money.

Let me illustrate using a hypothetical stock and nice round numbers. Let's say XYZ is trading at 50. I buy the stock at 50 and sell the 55 call at 1. That is just the same as selling the 55 put uncovered at 6! Think about it: In the buy write what's my maximum profit? If XYZ is higher than 55 on expiration you make 6. 5 on the stock plus one on the option. If the 55 put expires worthless what do you make, 6, right? What's your downside protection? In both the buy write and the uncovered put sale you start losing money if the stock goes 1 point lower, or 49. It's all the same!

And yet, any broker will easily let you do a covered write but throw their hands up in horror at the very idea of selling an uncovered put. Even though when you look at the P&L it's exactly the same!

Which is why all of you there can do your own homework and do far better than 90% of the investment advisors out there. Let me be your educational resource and then you make your own decisions.


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