Please note covered writing makes use of option contracts, in no way is it the same as investing in options. All other option strategies are extremely risky, which is why there are so many ‘cautionary’ statements made, as well as forms to sign when options are used in a portfolio. Covered writing is different.
According to the Chicago Board Option Exchange (CBOE) Web site: “The strategy of writing covered calls is actually more conservative than just buying stock, due to the fact that you have taken in premium and lowered your breakeven price on the stock position. The covered write allows you to be paid for assuming the obligation of selling a particular stock at a specified price.” (2005)
Please consider the following statements as the ‘risk’ of covered writing is considered.
When a stock is purchased, the investor is assuming the risk of losing some or all of the amount invested if the stock loses value and never recovers or the company goes out of business. As long as the stock is owned, there is the possibility of it increasing or decreasing in value over time.
When an option is purchased, the investor is assuming an even greater risk, because the option is only valid for a specified length of time at a specified price. If the underlying stock loses value, then the option to purchase that stock will also lose value. The additional risk comes into play if the stock does not recover in value prior to the option expiring. For this reason, the purchase of options is an extremely risky investment and cautionary statements are required. Purchasing of options as an investment is not allowed in IRA accounts because of this risk of loss and indeed "options involve risk and are not suitable for all investors."
An example and then a statement: An investor purchases 100 shares of a stock for $15 (net) a share, they would have invested $1,500 . . . (100 x $15 = $1,500) in the stock position. Simultaneously, this investor sold a $15 call option against this stock position and received $1 per share for the call, the investor would have 100 shares of stock and $100 in cash (100 x $1.00 = $100)or a net investment of $1,400. One of two things will happen. Either the option will expire and the investor will keep the stock and the $100, or the option will be exercised and the investor will receive $1,500 (minus commissions and fees) for the stock, but also keep the $100 premium received from the sale of the call option. IF THE INVESTOR DOES NOT DO ANYTHING, ONE OF THESE TWO EVENTS WILL HAPPEN.
Purchasing a stock is less risky then purchasing an option. Purchasing a stock and then selling a call option against the stock is less risky than just purchasing the stock alone. Going back to the example, a stock was purchased for $1,500 as mentioned above. If the company goes out of business, the purchaser would lose all of the $1,500. Now if the same stock was to be purchased and the $15 call was sold for $100 (Net), and exactly the same thing happened, how much would be lost? The loss would only be $1,400 because even though the company went out of business and the same $1,500 was lost as before ... the loss would be reduced by the $100 premium received from selling the option.
Covered writing is more conservative than buying stock. Don't just believe that ... even though it's true, take a moment and visit this link to the Chicago Board Options Exchange discussion of covered calls:
http://www.cboe.com/Strategies/CoveredCallOptions.aspx
It is recommended that the CBOE views and explanation of covered calls be reviewed. At the ‘Summary’, near the end of this web page, the following statement will be found:
"This strategy is actually more conservative than just buying stock, due to the fact that you have taken in premium and lowered your breakeven price on the stock position. The covered write allows you to be paid for assuming the obligation of selling a particular stock at a specified price." (CBOE Web Site, 2005)
The quotation above is not to be construed as meaning the CBOE agrees with, or recommends Systematic Covered Writing. The point being made, and verified, is that covered call positions are a more conservative investment than individual stock holdings involving the same stock positions, nothing more and nothing less. Covered positions are so conservative, that investors are allowed to establish covered call positions in IRA accounts.
The table below compares the type of investment to the degree of risk assumed by the investor.