Are Uncovered Calls Right for You?
Are uncovered calls suitable for you? Every investor and trader has to ask this question at the very beginning of consideration for any strategy. Uncovered calls are extremely risky because, in theory at least, a stock's market value can rise indefinitely. As a practical matter, a stock's potential price increase is limited, but it is impossible to know by how much; and that is where the risk factor is so extreme.
The level of suitability is determined by several crucial factors.
- Risk level and your ability to accept it. The most important test for any strategy is whether the risk level is appropriate. Can you afford the "worst-case" outcome? In the example of a covered call, the maximum risk is unknown, and it could be substantial. For example, what happens if you sell an uncovered call with a striking price of 50 and receive a premium of 6 ($600)? Without considering transaction fees, you would break even if the call were exercised when the stock's market value had risen to $56 per share. But what if the stock rises to $66. Or $76?
Some options traders are willing to undertake the risk involved with uncovered calls. Because three-quarters of all options expire worthless, the law of averages mandates that in a majority of instances, short options will not be exercised. But a string of modest profits can be easily wiped out by one unexpected rise in a stock's market price.
- Knowledge about the strategy and risk. No one should ever enter into a strategy without fully understanding the risks involved. Many first-time options traders become excited by the potential for profits, but ignore the equally important potential for loss. So a strategy like writing uncovered calls can be lucrative but also high risk.
Every brokerage firm is required to determine whether a customer has adequate knowledge to trade options. Before you are allowed to do any options trading, you will be asked to complete an options application and state your level of experience. But this requirement is only one aspect of the requirement for knowledge, and it is a requirement intended not only to protect you but also to protect your brokerage firm. Equally important is the more practical requirement that your actual experience match the strategies. You can easily claim to have extensive knowledge when you fill out a form, but you might not be fully aware of the actual risks you face when writing uncovered calls or undertaking other high-risk strategies.
- Experience as an investor or trader. Knowing the risks of an options strategy is all-important, but so is experience. Having a book-smarts understanding of uncovered calls is a good start, but you also need actual experience. For example, the knowledge that three-quarters of all options expire worthless might compel you to make a logical assumption: that uncovered call risks are not all that high. Since time value evaporates over time, selling calls with high time value reduces risks, as the logical argument goes. However, once you actually enter into a short option position, you are likely to discover that the strategy is not nearly as comfortable as you had thought.
Actual, real-money experience is an essential requirement for options trading. There is no substitute for it. The syndrome of theoretical experience versus real-world experience has misled many people. For example, in recent years, online gambling has become widespread. Anyone who has practiced card games online with artificial pots of money knows that the strategic play level is not the same as the play level with actual money. You might believe you are an exceptionally lucky card player. But when you put real dollars on the table, a man named Doc might quickly clean you out.
The same caution applies to options trading. Some strategies are highly conservative. Other strategies, specifically writing uncovered calls, are extremely high risk and not appropriate for everyone. Your experience as a stock investor and options trader is invaluable in knowing quite well what levels of risk you can afford to take and what levels you are willing to take.
- Income and investment capital. You need to have enough money in your portfolio to afford writing uncovered calls. Even if you believe you can manage the risk to this strategy, you cannot write an unlimited number of short calls. Your brokerage firm has to limit your exposure by law.
The Federal Reserve Board (FRB) has a hand in regulating how much risk you can have outstanding in your brokerage account. The FRB enforces Regulation T, which defines the level of credit you can have in your brokerage account. Reg T limits your borrowing power to 50 percent of the purchase price of securities. So when you write an uncovered call, your brokerage firm has to limit your risk by requiring that you keep the required cash level in your account.
Uncovered calls have a very specific margin requirement. When you write an uncovered call, you are required to maintain at least 20 percent of the stock's current price plus the amount of the call premium, and minus the dollar value that the stock is below the striking price. You are always required to maintain at least 10 percent of the stock's price even when this computation ends up with an amount below that level. Examples are summarized in the following table:
Call Written Current Stock Price Call Price 20% of Price Difference Margin Required 60 $65 $600 $1,100 $0 $1,700 50 50 300 1,000 0 1,300 40 37 200 800 300 700 30 21 200 600 900 210**The margin cannot be less than 10% of the stock price.
In the summary, the calculation is performed based on four different uncovered call scenarios. In the first two cases, the stock price is higher than striking price or equal to it, so no in-the-money difference applies. In the last case, the calculation is performed in the same way as in the other cases (call price plus 20 percent of stock value, minus in-the-money difference), but it produces a negative. The minimum required is 10 percent of the current stock price ($21 per share Ã 10% = $210).
- Personal investment goals. If you want to preserve your capital and take low risks, uncovered call writing is clearly inappropriate for you. Everyone has a set of personal investment goals, and it is not always a clear-cut issue of a strategy's being 100 percent appropriate or inappropriate. This is why some self-analysis is useful before putting money at risk. If you are a speculator and you want only high-risk and high-return strategies, then uncovered call writing is a great concept. But if you are saving for retirement, a child's college education, or to purchase your first home, uncovered call writing would be reckless. The approach calling for higher risk as a means for making profits more rapidly is often ill advised. If you cannot afford to lose money, you should not enter into strategies in which losses are very real possibilities.
- Brokerage approval level. Finally, your brokerage firm is going to assign you an approval level based on your experience as an options trader. These levels vary slightly among brokerage firms, but generally they follow the same restrictions.
For example, at level 0, customers are approved for the most conservative of strategies, such as writing covered calls. Level 1 allows customers to buy calls and puts and to enter other long-side advanced strategies in addition to all trading allowed under level 0. (Long-side means you cannot open uncovered short positions.) At level 2, customers can enter all strategies in level 1 plus more complex strategies known as spreads (more on this later in the book). Level 3 is the highest level, allowing customers to enter virtually every kind of option strategy and limited only by margin and brokerage restrictions. These include uncovered options and advanced strategies (short straddles and strangles, for example).
Your personal suitability is not limited to knowledge and experience. Brokerage firms assign levels based on capital available in your account, in addition to your skill level. For example, if the total value of your account is only $5,000, it is unlikely that you will get the highest approval level.
Risk and suitability are much different when you sell covered calls.