To my fellow Covered Calls investors,
Below are my answers and explanations regarding the six questions in Pop Quiz #2: Link to Post with Pop Quiz #2 Questions
Question #1. Covered Calls are best described as:
A. A stock investing strategy
B. An options strategy
C. A stock hedging strategy
D. A spread strategy
E. None of the Above
Below are my answers and explanations regarding the six questions in Pop Quiz #2: Link to Post with Pop Quiz #2 Questions
Question #1. Covered Calls are best described as:
A. A stock investing strategy
B. An options strategy
C. A stock hedging strategy
D. A spread strategy
E. None of the Above
The correct answer is C: Covered Calls are best described as a stock hedging strategy.
Only 4 of 27 responses answered correctly.
The most popular answer (17 of 27 responses) was: Covered Calls are best described as an options strategy.
I have been investing via Covered Calls since the late 1970s, but it wasn’t until I read “Option Volatility and Pricing” by Sheldon Natenberg in the mid-1990s that it became clear to me that Covered Calls positions are essentially a stock hedging strategy. Naternberg's book is one of the most widely read books among active option traders around the world. His discussion of Covered Calls is contained in the chapter titled “Hedging with Options”. I have always, and still to this day, consider myself to be a “Covered Calls investor”, but Natenberg refers to us as “hedgers”.
A definition of hedging is when you take a position to protect against losses in some other position. So, we take a position (think of us selling Call options on stock XYZ) to protect against losses in another position (think us owning shares of stock XYZ). I consider the best book written primarily about Covered Calls investing is “New Insights on Covered Call Writing” by Lehman and McMillan (if you don't already have it in your personal library you can get it here). In Chapter 4: "Turning a Position into a Strategy”, there is a section titled “Hedging Individual Stocks”. The first sentence says: “When you write a call against a stock position, you are reducing the downside risk of the stock position by the amount of premium you take in.” Therefore, establishing a Covered Calls position essentially enables us to reduce our initial cost basis in buying the stock by the amount of the Call options premium we receive from selling those options.
Now, regarding the most popular answer (17 of 26 responses) that Covered Calls are best described as an options strategy.
Yes, Call options are one of the two components of a Covered Calls position. However, the position includes both stocks and options and the Call options are used primarily to provide some downside protection (a “hedge”) to our long stock position; that is, some profit protection even if a small decline in the stock purchase price occurs. So, considering the role of both components of Covered Calls positions together, the most complete answer is that “Covered Calls are best described as a stock hedging strategy”.
Question #2. Covered Calls return-on-investment results are:
A. Better than a stocks buy-and-hold portfolio
B. Worse than a stocks buy-and-hold portfolio
C. About the same as a stocks buy-and-hold portfolio
D. None of the Above
A. Better than a stocks buy-and-hold portfolio
B. Worse than a stocks buy-and-hold portfolio
C. About the same as a stocks buy-and-hold portfolio
D. None of the Above
I decided that a reasonable case could be made for all of
these answers, so I considered all of your answers correct on this one. There was at least one person that chose each
of the four possible answers, but I was very pleased to see that 22 of you
chose A.
The introduction to my Covered Calls Advisor blog states: “The goal of this blog is to share information helpful to all who are interested in Covered Calls. It will demonstrate that by following an informed and disciplined process, Covered Calls investing achieves market-beating returns.” So although my own experience affirms my belief that Covered Calls do achieve market-beating returns, it is also heartening to see that so many of you agree. However, answer D is also appealing to me because I know that market-beating returns are not guaranteed. There are Covered Calls investors that experience answer C and unfortunately also answer B (for a variety of reasons, but most frequently because of poor stock selection).
Question #3. Covered Calls are _____________ than buying-and-holding stocks.
A. more risky
B. less risky
C. about the same risk
D. None of the Above
20 of the 27 responses answered correctly.
Several academic studies have concluded that Covered Calls portfolios are, on average, about 30% less risky than comparable buy-and-hold stocks portfolios. These studies are very technical and are often authored by experts in advanced mathematics and statistics. I have been unsuccessful in understanding all aspects of these papers, but my common sense informs me that their results are reasonable.
Question #4. The largest time value in a Call option occurs:
A. at-the-money
B. in-the-money
C. out-of-the money
D. None of the Above
The correct answer is A: The largest time value in a Call option occurs at-the-money.
There were 16 correct answers to this question.
There were 16 correct answers to this question.
Question #6. When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are:
A. The same as Naked Covered Calls
B. The opposite of Covered Calls
C. Almost Equivalent to Covered Calls
D. More Risky than Covered Calls
E. More Conservative than Covered Calls
F. None of the Above
The correct answer is C: When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are almost equivalent to Covered Calls.
There were 12 correct answers to this question.
This is an important concept to understand, so please commit the time necessary to carefully read (and re-read if necessary) these two blog articles. Each article addresses the close equivalence of Covered Calls and Cash-Secured Puts:
Bonus Question -- Take a Guess: What percentage of respondents will get all six questions correct?
The introduction to my Covered Calls Advisor blog states: “The goal of this blog is to share information helpful to all who are interested in Covered Calls. It will demonstrate that by following an informed and disciplined process, Covered Calls investing achieves market-beating returns.” So although my own experience affirms my belief that Covered Calls do achieve market-beating returns, it is also heartening to see that so many of you agree. However, answer D is also appealing to me because I know that market-beating returns are not guaranteed. There are Covered Calls investors that experience answer C and unfortunately also answer B (for a variety of reasons, but most frequently because of poor stock selection).
Question #3. Covered Calls are _____________ than buying-and-holding stocks.
A. more risky
B. less risky
C. about the same risk
D. None of the Above
The correct answer is B:
Covered Calls are less risky than buying-and-holding stocks.
20 of the 27 responses answered correctly.
Several academic studies have concluded that Covered Calls portfolios are, on average, about 30% less risky than comparable buy-and-hold stocks portfolios. These studies are very technical and are often authored by experts in advanced mathematics and statistics. I have been unsuccessful in understanding all aspects of these papers, but my common sense informs me that their results are reasonable.
Question #4. The largest time value in a Call option occurs:
A. at-the-money
B. in-the-money
C. out-of-the money
D. None of the Above
The correct answer is A: The largest time value in a Call option occurs at-the-money.
There were 16 correct answers to this question.
I thought a good way to show the answer would be to show a real-time example.
The green circles on the SPY options chain screen below show that the largest time value (also known as the extrinsic value) for both Calls and Puts occurs at the nearest-to-the-money strike price (in this case at the $337.00 strike price when SPY was trading at $337.04).
Extra Credit Question to think about: Given the options principle of Put/Call Parity, why do you think the time value in this example of $8.15 for the Puts is greater than the $7.54 for the Calls?
The green circles on the SPY options chain screen below show that the largest time value (also known as the extrinsic value) for both Calls and Puts occurs at the nearest-to-the-money strike price (in this case at the $337.00 strike price when SPY was trading at $337.04).
Extra Credit Question to think about: Given the options principle of Put/Call Parity, why do you think the time value in this example of $8.15 for the Puts is greater than the $7.54 for the Calls?
Question #5. The most likely time for a Covered Calls position to be assigned early is:
A. Anytime the option is in-the-money
B. When the stock increases from the purchase price
C. The day before the options expiration date
D. The day before the stock ex-dividend date
E. None of the above
The correct answer is D: The most likely time for a Covered Calls position to be assigned early is the day before the stock ex-dividend date.
A. Anytime the option is in-the-money
B. When the stock increases from the purchase price
C. The day before the options expiration date
D. The day before the stock ex-dividend date
E. None of the above
The correct answer is D: The most likely time for a Covered Calls position to be assigned early is the day before the stock ex-dividend date.
There were 16 correct answers to this question.
An excellent explanation of why this is true is provided in a
2012 article in the Born-to-Sell blog:
Read at link here.
Read at link here.
Question #6. When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are:
A. The same as Naked Covered Calls
B. The opposite of Covered Calls
C. Almost Equivalent to Covered Calls
D. More Risky than Covered Calls
E. More Conservative than Covered Calls
F. None of the Above
The correct answer is C: When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are almost equivalent to Covered Calls.
There were 12 correct answers to this question.
This is an important concept to understand, so please commit the time necessary to carefully read (and re-read if necessary) these two blog articles. Each article addresses the close equivalence of Covered Calls and Cash-Secured Puts:
Bonus Question -- Take a Guess: What percentage of respondents will get all six questions correct?
The answer is 0%
I hope your knowledge (and curiosity to continue learning) about Covered Calls investing is increasing from these Pop Quizzes. I am pleased that 27 people responded to this 2nd quiz. This response encourages me to consider the possibility of creating Quiz #3 before the end of this month.
Hint: There will be at least 2 questions developed from the information written above in the answers to these six questions included in Pop Quiz #3.
Best Wishes and Godspeed,
Jeff
I hope your knowledge (and curiosity to continue learning) about Covered Calls investing is increasing from these Pop Quizzes. I am pleased that 27 people responded to this 2nd quiz. This response encourages me to consider the possibility of creating Quiz #3 before the end of this month.
Hint: There will be at least 2 questions developed from the information written above in the answers to these six questions included in Pop Quiz #3.
Best Wishes and Godspeed,
Jeff
