The Covered Call

Vol #6 - September 11th, 2020

Why would you sell an option if you thought the stock was going up?

It’s a great question. I frequently hear this as a first reaction upon learning about options. “Covered calls” is one of the first options strategies introduced, and it sounds like a contradiction in terms.

You start to understand the stock market, and quickly realize that you want to buy stocks that are low, and sell them when they’re high. Easy enough. Enter the covered call, and all of the sudden you’re not selling the stock, but something else. And if you think the stock might go down, why not just sell the stock? Why would you sell a call?

The truth is, if you really think the stock is going down, you should sell it, or use a strategy other than a covered call. It’s a great strategy, but not a panacea. It’s just a trade-off.

All options strategies are about trade-offs. We all have different preferences, and the markets are a way to express those preferences through financial contracts. You don’t sell the call because you think stock is going up, you sell the call because the certainty of money now is worth more than the potential of more money later.

The strategy part is also important here. If you sell a call and the stock goes up, that’s just one trade. A covered call strategy is about doing that over time, because on average you’d prefer a little more of your returns in income than growth potential.

There are enough professionals scouring the markets for opportunities, to ensure that there are very few free lunches available. Covered calls don't provide a magic source of income, and selling volatility isn’t a lock. What options strategies do provide, is a means for diversification and preference matching.

Covered calls are one way to use options to exchange outcomes, but that concept applies to all strategies. Purchasing coverage for your portfolio says you value stability more than absolute returns. Capturing skew and volatility premium is a way to generate cash flows by assuming additional risk.

Harvested Financial was built to help match investors to their trade-offs. We build and execute systematic derivatives strategies to tailor individual client returns. When your investments are aligned with your objectives, there’s no wrong side of a trade.

Thanks for joining us,

Mark Phillips
CEO

What clients are asking us:

• Do I need to understand the greeks?

  • There’s a pretty cool Greek philosopher we talk about below, but understanding the options greeks isn’t necessary at all. If you’re into math and trading strategy, there’s a lot to talk about, but for most people the only important greek is delta. Delta can be interpreted as either the rate or probability of change. Something that’s 25 delta, has a 25% chance of happening.

• What do you mean by behavioral alpha?

  • That’s a great question, because it’s also fresh on our blog this week! In short, behavioral alpha is the excess return that comes from disciplined investment strategies. Harvested Financial builds strategies to add rigor through serial implementation and Odyssean contracts.

• What's the difference between an advisor and a broker?

  • As an advisor, we're your fiduciary. This means we do more than execute trades, we help you customize a strategy and financial plan that is in your best interests. We're here to serve you and help you meet your goals. While a broker can execute a trade per your instructions, we work to understand how money matters to you, and bring that plan to fruition.

Happy Friday!

Options have a long and interesting history. While the modern day contracts that Harvested Financial uses for your portfolio only started trading in 1973, there is a long history of options like contracts, dating back to ancient Greece.

In his opus "Politics", Aristotle describes the aspiring philosopher and world's first option trader Thales Miletus. Poor and ridiculed by his peers for his lack of success in either writing or commerce, he thus committed himself to earning a fortune so he could dedicate his days to the pursuit of knowledge.

With little capital to start out with, Thales was on the hunt for opportunities that offered significant growth potential for a small capital outlay. After studying the heavenly bodies and observing weather patterns, he became convinced that a bountiful olive harvest was forthcoming. The general consensus of olive producers was the opposite.

Thales began to look for ways to bet on a bumper crop. There was no olive futures market, so he looked for more indirect ways. The presses which are used to produce the oil were available for lease in advance. He secured all the available presses he could with his borrowed funds and waited for the harvest.

The worst case scenario would be a loss of his deposits - unfortunate, but limited. His upside however, was potentially unlimited. The more olives were harvested, the more the presses were needed.

True to his prediction, the season produced an excess of olives, and the presses were in high demand. Thales now had the exclusive right to use these presses, and was able to lease them out for much higher rates than he had paid. His option on the olive presses paid off in multiples.

Thales was now free to live the simple and unburdened life of a philosopher, no longer mocked for his lack of success in commercial affairs.