Covered Calls are for SUCKERS… (Part ONE)

By
Kurt Frankenberg
– May 12, 2011Posted in: RadioActive Profit Machines
Hey, sorry about the title if you’re trading covered calls… but I have to call it like I see it.
By the way, every Tuesday and Thursday at 12:00 noon I teach a free webinar that gives a solution to the two biggest problems with selling covered calls. So, if you’ve been “bit” by this particular trading technique… or simply haven’t been making the returns you had hoped to… you owe it to yourself to go check out that webinar.
That said, on to my assertion: “Covered Calls Are For SUCKERS”.
Ahem.
Well, let’s take an example of three traders, all of which are bullish on XYZ. We have a covered call trader, a fella that likes to buy long calls and puts, and of course… the market maker.
Yeah, he’s a trader too. A lot of people forget that.
So on to the vital statistics:
Let’s say that each of the “retail” traders is using $100K in their account. We’re looking at XYZ, trading at $50. The June $50 calls are trading at a bid/ask spread of $1.80 X $2.00.
The covered call trader puts $100K into buying XYZ at $50 and gets 2000 shares. This enables him to sell 20 contracts of the June $50 calls for $1.80. That’s 20 X $1.80 = $3600, or 3.6% gain on his $100K should he get called out at expiration! And that’s just what the “gurus” promised him, between 3% and 6% per month, monthly income. GOOD for him! (Maybe…)
Let’s talk about the other “retail” trader. He picks up 18 of those contracts at $2.00, costing a total of $3,600. That’s 3.6%% of his capital being put AT RISK… rather than shoot his whole wad he is practicing responsible “money management’, “bet sizing”, or as famous trading coach Van Tharp calls it, “position sizing”.
Rather than TAKING 3.6%, he is RISKING 3.6%, the long call buyer has leveraged himself by paying pennies on the dollar for control of this stock.
Finally, the market maker: He’s buying contracts at $1.80 and selling them at $2.00. IN the case of the volume of 20 contracts for the day… he has passed along 18 and kept two for himself. For each nine calls that he sells at $2.00, he finances the purchase of ten calls at $1.80– and keeps one for himself.
😉
Okay, so XYZ gets a bump. It goes up 10% to $55. How does this pan out for everyone?
The covered call trader of course gets compensated the $3600 or 3.6% on the money he started with.
The long call BUYER does a little better: his $50 calls are now worth $55. He had put up $2 for each one, so has a $3 profit. On an investment of 18 contracts, that puts $5,400 in his account for a gain of 5.4% on his capital. Nice going!
Mmm… and the market maker? Well, in this transaction alone his return on investment is INFINITE. Yes, that’s right… because he was buying at the bid and selling at the ask, the market maker is able to hold onto a small number of calls for a zero cost basis. That’s his incentive to provide liquidity in this market, after all. When XYZ bumps up, each of the calls he bought for… essentially NOTHING… are worth $5! When you divide the return that he got by what he had invested…
Well, you CAN’T divide by zero, but when you try you get infinity. The market maker gets an infinite percent return because he CAN gain, but can’t lose. The two contracts that he kept as a normal course of trading make him $1,000, on an invested amount of… nothing. Except his time of course.
Wow, you might be saying. IN the scenario above, everybody wins (I’ve heard it said that in a bull market, everyone’s a genius)!
But then… what if everybody takes their winnings and plays again? Let’s use the same position sizes and details of the trade, only this time around XYZ FALLS by 10%. What will everyone’s situation look like then?
Well, the market maker in this scenario loses… nothing. He was bullish on XYZ, turned out to be wrong… but he was BULLETPROOF. Why? Because every call he turned over made him a .20 cent spread. Every nine calls would enable him to buy the tenth “free”. Talk about frequent flyer miles!  So, while the market maker did work hard hooking up the buyers and the sellers he does not win… but he doesn’t really lose either. 😎
The buyer of long call contracts does lose… because he put up $3,600 to buy 18 contracts at $2.00, he is down 3.6% on his capital of $100K.
Oh, and the covered call trader? Well, his stock may be down by 10%… which is $5 on each of 2000 shares… but that $10,000 loss is offset by the $3600 he received for selling calls. That’s a net loss of $6400, or 6.4% loss.
Let’s make a table out of this data, shall we?
Trader                      Wins         Loses       Net Total
Long Call Buyer        5.4%          3.6%       Gains $5400 – $3600 = $1800
Market Maker           infinite%!     0.0%       Gains $1,000 – $     0 = $1000
Covered Call Seller    3.6%          6.4%       Loses $6400 – $3600 = $2800
Chance rules: everybody wins some, loses some according to the ups and downs of the market. All three traders were bullish on XYZ; they expected it to go UP, not down! But each of the players in this little drama structured themselves differently and were therefore PAID differently according to the winds of fortune.
By making something when he is right and losing nothing but time and energy when he is wrong, the market maker is killing it. Only made $1,000? Well, REMEMBER… not only did he put up zero capital for this play, but he was the middleman between the buyer and the seller of just this one transaction. And there are PLENTY of covered call sellers and and long call buyers.
Oh, and the long call buyer in a scene structured like this can afford to be wrong as often as he is right, because of HIS “money management” structure of only risking a small percent of his stash. He loses only 3.6% when he is wrong… but makes 5.4% when he is right! So he makes a NET profit out of one winning and one losing trade with the above money-management parameters.
Wow, both the market maker and the long call buyer seem to be making money. But this is a zero sum game, right? How can we possibly finance the consistent wins of these two players?
Ahhh… by finding someone willing to MAKE LESS when they win and LOSE MORE when they lose.
Can you pick out that fella from the above table?
Ouch.
Seems the $1800 gained by the long call player on $100K of invested capital, and the $1,000 gained by the market maker on zero capital outlay… come to a combined figure of EXACTLY what the covered call player LOST: $2800. Hmmm…
Ever wonder why covered call plays are the first thing most recreational investors get cleared to trade 😉  ?
Yup. As Warren Buffet has said… if you are sitting at a poker table for fifteen minutes and haven’t figured out who the patsy is… YOU’RE the patsy!
I’m sorry if this post hits you a little close to home. I feel your pain. I really, REALLY hope you have never been hurt as badly as I was with the strategy of selling covered calls.
But that isn’t why I’m writing to you.
I’m writing to you not about the problem… but about the SOLUTION that I discovered about ten years ago, and that I have been teaching people about for FREE for nearly as long.
While you and I may not be able to buy at the bid and sell at the ask… there are some conditions under which we may be able to reduce the cost basis of our stock insured by a put option… and do “Income Methods” that CAN win, but CANNOT lose.
Would you like to occupy the seat of the money maker, reaping where you do not sow? Heh… me too…
By the way, every Tuesday and Thursday at 12:00 noon I teach a free webinar that gives a solution to the two biggest problems with selling covered calls. So, if you’ve been “bit” by this particular trading technique… or simply haven’t been making the returns you had hoped to… you owe it to yourself to go check out that webinar.
In the next post I’ll be sharing how you may be able to get to that place of the infinite leverage normally reserved for the money maker.
Hey, does THAT sound appealing? If so, lemme know and post below!
…sorry, my muse is out to lunch so those are the rhymes you get 😉
Happy Trading,
Kurt
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About Kurt Frankenberg

Kurt Frankenberg is an author and speaker about entrepreneurship, martial arts, and trading the stock and options markets. One of several "Biznesses" he founded as a teen, The Freedom School of Martial Arts, has been in continuous operation since 1986. Kurt lives in Colorado Springs with his wife Sabrina, German Shepherd Jovi, and his ninja cat Tabi.