Courtesy of Dr. Paul Price
Covered Calls – The Hidden Risk for 2013 and Beyond
I’ve scaled way back on covered call writing (selling calls) lately.
For the last three decades, writing calls has worked very well for me. Writing calls on shares of stocks is the simplest, most conservative approach to option trading. "Covered call writing" means
- you own the underlying shares (each sold call is "covered" by 100 shares of stock), and
- you're agreeing to sell 100 shares, or some round multiple of 100, for a set price through a predetermined expiration date.
Note: Selling one call is making a contract to sell 100 shares of the underlying stock at a particular price on or before a particular date. In a "covered call" scenario, because you already own the shares, you do not risk being forced to buy the shares at higher prices. Selling a "naked call," in contrast, means you don't own the shares and would have to first buy them to sell them – if the stock is dramatically higher, that would entail a significant loss – it's a much riskier trade.
Here's a generic example of covered call writing:
So what’s not to like? Why have I been reluctant to use this strategy?
Because, in the crazy world of QE Infinity, there is a real possibility of a market melt-up due to a major dollar devaluation.
A look at December’s action in the Japanese Yen and the Nikkei 225 shows how this could play out in the U.S. Although Japanese stocks traded higher, Japanese companies didn’t become more valauble in real terms. Shares surged because the local currency collapsed.
Japan’s newly reinstalled Prime Minister Shinzo Abe declared his intent to print unlimited Yen. He intends to increase government borrowing to fund public works projects.
The U.S. central bank – the Federal Reserve – is also printing money to fund government spending. As the U.S. continues down this road, the value of the U.S. dollar will continue dropping.
We all tend to forget where prices were years ago. Here’s a reminder:
The bulk of the inflation between 1972 and now came without the printing presses running full speed ahead. Now they are. As I argued in Washington’s Biggest Lie (and Why it Continues to be Told), Washington has been lying about true rate of inflation. At some point in the future, America will see much higher prices on everyday goods. The only question remaining is on the timing.
In this environment of price inflation, stocks should do extremely well on a nominal basis. They represent true earnings power rather than fiat-based (full faith and credit) pieces of paper. Selling covered calls now is betting that you can predict when a big rise in share prices will occur – because when that happens, having sold calls will forfeit the upside to stock appreciation.
Our market will ultimately skyrocket on the dollar becoming “worth less” rather than “worthless.” The last thing you would want in that environment is to have your real assets turned back into paper money. That’s the risk we’re now taking when selling call options.
Potential premium income you get from committing to sell at a set price months in advance may pale next to any sudden price surges. You might very well get away with it for a few option cycles only to lose big when the ultimate flight out of paper money finally happens.
If you do not anticipate this possibility in advance, it will probably be too late to fix. This unexpected risk is not being priced in now because it appears to be such a black swan event.
I’m going with the old adage, “Failing to plan is planning to fail.” This is not a good time to be selling calls.
