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June 18, 2019 / 7:16 PM / a year ago

Uncovering the Truth About Covered Calls

How safe does a “covered call” sound? “Covered” may sound like there is some safety or guarantee involved. Contrast this with another option strategy: a “naked put.” A “naked” investment may sound risky. But perception does not always align with reality when it comes to covered calls and naked puts—they effectively have the exact same risk.

How could that be true? What exactly does “covered” or “naked” mean for these types of investment contracts—better known as options? Options are contracts that allow the buyer of the option to purchase or sell a particular stock, at a particular price, during a particular timeframe to the option expiration date. Call options give the buyer the right to purchase a security at a certain price to the expiration date, whereas put options give the buyer the right to sell a security at a certain price to the expiration date. The seller of a call hopes that the stock price does not rise over the time period of the option contract, whereas the seller of a put option hopes that the stock price does not fall.

If you sell a “covered” call, it means you are writing a call option on a security position you currently own. You can earn income from selling the call, but if the position rises to the specified strike price prior to the time the option expires, you may have to  sell the stock at the strike price to the owner of the call option. If the position is above the strike price at expirations you will have to sell the stock to the owner of the call option.  If the stock price does not rise to the strike price, you keep the stock and the premium from selling the call option when the option expires. What’s the risk? At first glance the worst case scenario seems to be that you are forced to hand over your stock at a lower price then where it is currently priced.

On the other hand, selling a “naked” put involves writing a put option on a position you don’t currently own. You receive the immediate income from selling the put, just like the covered call. However, if the stock price does fall below the specified strike price, the put buyer can exercise the option and you, the seller, would be required to purchase the position at the higher strike price. Why are these “naked” puts often considered the riskier of the two? Essentially, the stock price could plummet all the way down to zero—so the potential loss is the difference between the strike price and zero. If that happened, you would have to purchase the stock at the strike price, even though the stock is now worthless. Contrast this to the covered call’s maximum risk, which appears to be that you must sell the stock at the strike price of the call.

However, appearances—and adjectives—can be deceiving. When you examine covered calls and naked puts from a mathematical level, you find that they end up with the same payout. Don’t believe it? Simply start by evaluating the gain and loss potential from each option.

Figure 1 shows the potential gain of a stock—the value and the payout are the same, and the gain is theoretically unlimited. The potential loss is the purchase price.

Figure 2 shows the potential payout of writing a call option. The highest gain is limited to the premium received from selling the option. However, there is unlimited loss potential if you do not hold the security in question. If the stock price rises to the strike price and you do not own the security, you’d have to purchase it at market price and hand it over to the option buyer at the strike price. The stock’s actual price could have had unlimited appreciation—but you would still have to purchase it and hand it over to the option buyer at the lower price.

Figure 3 shows the combination of holding the stock and selling a covered call. Past the strike price x, the potential gain is capped. If the stock price doesn’t hit the strike price, you still own the stock and the risk that comes along with stock ownership. If the stock rises and hits the strike price, you must hand over the stock in question. Therefore, you no longer have access to the stock’s theoretically unlimited gain potential. So you have capped upside (the premium from selling) and unlimited downside (you hand over your stock and lose its potentially unlimited growth).

The result looks like Figure 4.

Compare this to Figure 5, the possible payout of a naked put. The outputs are exactly the same.

How does that work? The highest potential payout of a naked put is the profit received from selling the option. You can experience all of the risk that would occur if you held the stock in question, but the upside is limited only to the premium received from selling the option—none of the stock’s potentially unlimited gain over time.

We can see that both the covered call and naked put have the same capped payout. Favoring covered calls over naked puts is not based in mathematical evidence—it’s a cognitive bias! We think of certain words or phrases as indicating safety or security. But those phrases don’t always truly describe the risk and potential of an investment.

Perception can be misleading. The comparative “safety” of a covered call versus a naked put is mostly interpretation. Look beyond initial judgement when considering these or other investment products. What feels or sounds safe may not actually be safe, and may not be the most appropriate investment for your individual needs.

It’s tempting to pursue what sounds like an easy win when it comes to investing—but taking the time to actually evaluate what a particular financial security is and how it works can be more useful to you in the long term. When considering an investment, break it down to its fundamental level. Don’t get carried away by advertisements or adjectives that may lead you down the wrong investing path for your future.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return.  This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

The Reuters editorial and news staff had no role in the production of this content. It was created by Reuters Plus, part of the commercial advertising group. To work with Reuters Plus, contact us here.

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