I recently heard an options trading investor suggest that writing covered calls is a strategy that can be utilized only by investors with a big pile of cash.
That is simply not true. Writing covered calls is a strategy that can generate solid returns and is in no way restricted to traders with large accounts. As a long time option educator, I know that options investing and trading can be confusing. Nevertheless, I never heard anyone suggest that investing in stocks is only for the wealthy.
Put simply – to write covered calls, the investor must own at least 100 shares of stock. There are many quality stocks which trade between $20 and $40 a share. Surely buying 200 shares of a $35 stock and writing two calls is not a situation reserved for the wealthy. It requires less than $7,000. While that may be a significant sum for many investors, it hardly separates the wealthy from the non-wealthy investor.
For purposes of diversification, it’s more efficient to own a few stocks rather than only one, and I’d advise people with smaller portfolios to begin by investing in index funds, while steadily adding money to their accounts. When there’s enough value in the account, and if the investor prefers to handle his/her own trades rather than continue to use index funds, then that’s the appropriate time to begin writing covered calls. $20,000 should be more than enough – and yes, I recognize that many investors begin using options with far less capital.0
Alternative strategy: Sell put spreads
When a trader recognizes the large downside risk associated with owning stock (with or without writing covered calls), he/she may feel much safer by using alternative bullish strategies. One easy to understand strategy is the sale of out-of-the-money put spreads.
The maximum profit may be limited to the cash collected, but the maximum loss is drastically reduced, and is far less than that associated with owning stock. Any trader who is happy to earn profits with reduced risk should prefer the sale of put spreads to the purchase of stock and the subsequent writing of call options.
Translation: Selling put spreads is preferable for conservative investors who want to limit downside risk. There is no suggestion that everyone should adopt this method rather than own stocks.
For example – when a trader sells a 5-point spread, the XYZ Nov 50/55 put spread — the maximum loss is $500, less the premium collected. Additionally, the margin required to hold the trade is only $500, far less than paying the $2,500 margin required to own 100 shares of a stock priced at $50.
Recognize that there is no need for great wealth to trade this strategy on a small scale. Note those words: ‘small scale.’ The biggest risk associated with this play is the inability to recognize the possibility of losing the maximum ($500, less premium collected). That encourages the not-yet-educated options player to sell 10 of these spreads instead of buying 100 shares. To that trader, each position has $5,000 at risk. There is little chance of losing the entire $5,000 when owning shares, but the chances of losing that (almost) $5,000 from the sale of 10 put spreads is far greater than zero. That’s the risk – selling too many spreads.
To trade options with less capital, it’s advisable to look for risk-reducing spreads. And it’s necessary to trade an appropriate quantity of spreads.
Follow Mark on his ‘Options for Rookies’ blog: http://blog.mdwoptions.com
