Covered Writing - A Way to Reduce Risk?
Len Yates

Covered writing, also known as a "buy write", is often touted as a safe way to generate extra income from a stock portfolio, and the Short Covered Call is often an investor's first introduction to trading options. It follows naturally from the simple purchase of stock. It is relatively easy to explain and results in immediate income. And finally, it seems to be just as safe as simply investing in stock. 
 
While speculative call buyers usually hold their position for only a short time, the covered call writer often expects to hold his position to expiration. If the option is out-of-the-money at that time, it expires worthless. If the option is in-the-money at expiration, the investor may decide to buy the option back to close the position and keep his stock, or he can do nothing and see his stock “called away”.
 
Some investors keep their stock and sell covered calls repeatedly after each expiration, thus continually adding to their income. A real plus is that covered writers make money during periods when their stock holdings go nowhere. And the income that can be generated can be impressive. Upwards of 20% annual returns are possible. But that kind of return is possible only if the stock goes up or remains at around the same price.
 
When someone says they don't trade options because they're too risky, the covered call is usually cited as an example of using options to reduce risk. And it's true. The sale of call options against existing stock holdings does reduce the overall variance of returns, thus reducing risk in the traditional sense.
 
However, if you take the time to study this strategy and its risk curve, it can in fact be a risky way to invest. The risk curve for this trade looks like, and in fact is exactly the same shape, as the risk curve that results from simply selling a naked put. While covered writing is attractive because of the extra income it generates, it also has a major shortcoming. The covered writer has the same downside risk as he did when he just owned the stock. At the same time, his upside potential is now limited.
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