Customer Reviews

New Insights on Covered Call Writing: The Powerful Technique That Enhances Return and Lowers Risk in Stock investing

5 star:		(9)
4 star:		(8)
3 star:		(3)
2 star:		(2)
1 star:		(1)

 

 

I liked this book and would recommend it to those interested in covered call writing. There are a few things to keep in mind while reading this book:

1- McMillan is a very well established authority on option strategies, I remember reading his options books way back in 1984, when I was the local options specialist at Dean Witter. However, if you read his comments on covered call writing in his other books, he's much more guarded with his support than he is in this text.

2- Nowhere in the book do the authors discuss the extreme increase in time and especially paperwork that is required to successfully implement this strategy. I've always thought of managing an equity portfolio as investing (mostly passive), managing covered call positions is more like work (trading takes lots of time and effort to do it right). That's OK, call writing also reduces risk and gives you a lot more control, but be prepared to invest a lot of your time.

3- In my experience, most people really have a hard time with this strategy. Yes, it's easy to implement, but most dedicated options traders find this a bit too basic for their interests, and it ties up too much capital. Most equity investors have a hard time with the amount of work, loss of long-term capital gains impacts, tax reporting headaches and giving up some appreciation potential.

4- The 20 stock study described in the book is very misleading. For some reason the positions with 163 months of data show covered writing (CW) underperforming a buy-and-hold (B&H) strategy by about 700 basis points. I don't know if this is due to a flaw in the data or something to do with option premiums in the early years of the study. Data from comparing
CW returns to BH returns for periods less than 163 months show identical returns between the two strategies. This is consistent with results from more rigorous academic studies, which generally show underperformance of covered writing of 30 to 50 basis points. This is also consistent with my own experience. This makes sense, since covered writing is slightly to moderately less risky than buy-and-hold investing, the returns should be similar or slightly lower.

5- I was amused at the author's description of how he traded a client account. Frankly, trading in the way described is not a viable approach to investing. Covered call and cash backed put writing is best used to hedge and to reduce the volatility of returns. That's a whole different ballgame from the way the author traded the account in the book.

The people who usually succeed with covered call writing tend to be really good percentage thinkers, very organized at tracking and analyzing investment results, and good with the basic record keeping. Those who thrive at it really love it, but it's not for everyone.

I wish the book would have addressed these issues. Also, there is a lot more strategy involved in managing a covered write portfolio than was discussed in this book. To my mind, the subject was over-simplified here. I think the book also should have spent more time suggesting cash-backed put writing, which is the sister strategy (and has equivalent risk and returns) to covered call writing.

Still, it's a very good book, and one I recommend without hesitation. I'm a big advocate of covered call writing and cash-backed put writing for those who are willing to take the plunge.

I also highly recommend The Conservative Investor's Guide to Trading Options by Leroy Gross (with a forward also by Larry McMillan).

This is a good book if you already have a grasp of the basic concepts of covered call writing but are more interested in the details of why covered call writing works rather than how to use the concept to make money. The author spends a lot of time going through esoteric details on black scholes models and comparisons between the buy and hold and covered call strategy but little time is spent on providing real market examples on how to use the concepts in the book to make money. As an investor and trader my main purpose of reading any book is to learn the "how to" practical concepts that work in real market situations to enhance my profits and this is where this book is deficient. Furthermore this book does not get into the art of picking the right stocks and the timing criteria needed to decide when a covered call is a good strategy and when it is a losing one.
This book deserves at least 4 stars for explaining the covered call concept in great details and proving its usefulness. To make the best use of this book you need to couple it with one that will give more practical examples on using these concepts in real life situations in addition to strategies of picking the right stocks to write covered calls on and critical timing strategies. The book that worked best for me was the recently published September 2003 Second Edition "generate thousands on your stocks without selling them " By Elias. Elias's book has extensive real market examples with many innovative and profitable concepts.

This is probably not the first book you want to buy if you are like most stock investors who are trying to grasp covered writing and get started for yourself. It was written by a good technician, not a great teacher. I have no doubt that everything said in this book is accurate, but much of the information presented is on the fringe of what is necessary for most covered writers to learn how to get the job done. For me, a more simplified, step-by-step discussion on "how" would have helped with less discussion on "why." For those who want it, the technical aspects are done in great detail (e.g., 1. much discussion about Black Scholes valuation formula, 2. an enormous amount of space devoted to going back in history to demonstrate that covered writing can match returns of simple buy-and-hold stock ownership. Why spend time and space on this when knowledgeable investors are saying that stock performance in the next decades won't be anything like the past ones?). There are sections devoted to subjects that don't have anything to do with covered writing, but unfortunately less than one page was given to covered writing on Exchange Traded Funds and hot items like the QQQ. For me at least, I thought that the implementation section was the least useful part of the book. This book might help if you are interested in some of the more complex and esoteric aspects.

As a professional in this industry, I was impressed with the book though it is hard to be certain how much was written by McMillan... There are better books to be sure, but it is tough for the average investor to start their education in options with a tome like "Options as a Strategic Investment" by McMillan (though it is fairly comprehensive and well written.) This book does a great job helping a stock investor transtion to an options investor by introducing some "baby steps" coupled with "grown-up" concepts. Covered calls are a preferrable start over more agressive strategies for those who are new to the subject matter. This book will serve new options investors quite well, and remind experienced options players of the important fundamentals.

I expected a bit more from these authors. There is a wealth of data (too much) showing the viability of this strategy. This book provides convincing evidence that covered call writing is an excellent strategy - a stratgy I discovered last year after reading THE SHORT BOOK ON OPTIONS, which I also recommend.

The short book goes deeper into the basics of options. Lehman's book is for the more advanced options student.

Read both books and adopt this investment strategy. You won't be sorry (based on my profitable first year of using options)

This book is an excellent primer on one of the safest form of the options game, at least from the perspective of the brokerage industry. So, if you're bored with watching your portfolio creep around at a few percent a day, you can write (sell) a call option for $100 on a $5000 investment (for example) and have a pretty good chance of keeping the 2% at the end of the month. Lehman and McMillan do an excellent job of providing return formulae and web resources for further research. But the question remains: do you really want to get into this? (I admit it's addictive). If you do you'll turn into your own stock churner. The brokerage fees aren't too bad if you use one of the discounters, but get ready to do some major capital gains calculations (profits from unexercised options are all short-term capital gains). Here's a hint: this is NOT the way Warren Buffet got rich.

I found this book to be excellent, really, but some of the nitty-gritty details about covered writing were missing. Such as computing returns in a margin account. Interestingly, McMillan covers those details in one of his other books -- Options As A Strategic Investment, so I guess I'd recommend that as a complement to this book. Overall, though, I found this book informative in the philosophy of covered writing -- why you'd want to use that strategy, and what you'd benefit by doing so.

In my view, you will not find a better education on options or covered call writing anywhere. I wish other investing books were written this thoroughly. After reading this, I see now that other sources greatly oversimplified covered writing and frequently promised unrealistic returns. This book gives you all the ins and outs so you can judge for yourself what is possible, based on how you implement it. It is not beyond the capabilities of most people -- it just takes a little time to learn it and determine how best to make it work for you. I had no idea it was so flexible. The strategy makes great sense for me, yet my stock broker never even suggested it. Instead, he kept insisting I just hold on to the stocks he recommended as they kept declining. Maybe now I should teach HIM a thing or two!

As I view it, there are two key questions relating to any complex investment strategy:

1) Why? Why should I pursue this strategy versus my current (probably simpler) strategy?
2) How? If the proposed strategy is indeed worthwhile, how can/should I implement it?

This book does a reasonably good job of answering the second question, with details on how options work, and a discussion of things like getting approval to trade them, tax issues and the like. I'd read some similar material elsewhere (including CBOE's own site), but this book pulls together a lot of disparate information, and filled in some holes in my own somewhat meager understanding of the mechanics of trading options.

However, showing HOW to trade options is not very important, IMO, if one cannot show WHY one should trade them in the first place.

The book jacket is not very encouraging in this light - mentioning that "Returns of 10 to 15 percent per year in conservative accounts - and as much as 20, 40, or 60 percent per year in more aggressive accounts - are possible". Of course, like most investors, I would be thrilled to get 60 percent annual returns, but experience and reading have taught me that those advocating investment strategies and making claims of that magnitude are to be taken with a BIIIIIIG grain of salt.

Within the book itself, sky-high claims like the above are (fortunately) not emphasized. But basically, three rationales are presented for covered call writing:

1) Ability to obtain superior returns through knowledge of the future direction of a particular stock (i.e. if you think/know Microsoft will go up/down in the next month, then do XYZ...)

2) Ability to use more leverage (there is a long discussion of how different scenarios are treated from a margin perspective, with an emphasis on controlling larger blocks of stock/options for a given starting investment)

3) Reduction of risk, possibly without significant reduction of return

Personally, I think that markets are reasonably efficient, and that I lack and real ability to outpredict the market with regards to returns on specific stocks (once I normalize for various risk characteristics). So rationale 1 above holds no appeal to me. [EDIT - 2011 follow up. I'd say I've softened my stance a bit with regards to prediction. But the main area where I've got first hand experience with market inefficiency in individual securities is closed end funds, which are not optionable in the U.S. (unless I've missed one or two), so my general thinking here re: options still stands reasonably well.]

I am also not interested in increasing the leverage of my portfolio, and further, if I was, I think there are probably simpler/cheaper/more efficient means of doing so other than writing covered calls.

That leaves rationale 3, which was what sparked my interest in reading this book. The author briefly discusses the BXM - an index created by the CBOE in conjunction with some research showing that a buy-write strategy (owning a broad index and mechanically writing calls against it) produces about the same return as owning the index itself, but does so with significantly less risk/volatility. But the authors' discussion of this research is short - about two and a half pages, and gives minimal or no mention of some important issues:

1) The BXM strategy involves writing calls every month. This will create a variety of costs - brokerage fees, spread/transaction costs, taxes, and time. While these factors may affect any mechanical strategy (including indexing itself), they are likely to be much more severe for the BXM strategy.

2) The BXM strategy is a backtested strategy. It's relatively easy to find strategies that would have outperformed the market in the past, given what we know now (Consider the MICROSO strategy - buy at IPO any stock that begins with the letters MICROSO), but one should approach such strategies with caution. It's much harder to identify and implement strategies that will work for the FUTURE, and that are in fact proven to do so over the subsequent decade or two.

3) The market itself may have changed. Writing options is relatively more attractive if call premiums are high. It appears, based on evidence presented in this book and elsewhere that I've seen, that call premiums have generally been higher than they *should* have been (per Black-Scholes). This, in turn, has made call-writing more profitable than it otherwise might have been. But markets change over time, and it's quite possible that call premiums might trend downward (or may have already done so), towards, or conceivably even below, 'true value'. I don't know if this is the case, but it's something for a potential investor to be concerned about, and isn't well addressed in the book.

The authors' also conduct their own study looking at writing options on a basket of individual stocks. While the results are interesting, the study is flawed - they emphasize tech stocks, and in their limited pool of 20 companies studied, one they've chosen is Microsoft, starting in 1988! At that time, I think, Microsoft was a relatively small company (it had only gone public in 1986), and it seems unlikely that someone selecting a portfolio of 20 (hopefully representative) companies to own and write options on would have chosen Microsoft. For what it's worth, the study finds that a covered call strategy on Microsoft underperforms buy and hold in absolute returns, which should hardly be surprising (writing covered calls means giving up some upside, and Microsoft had a LOT of upside during the time period covered), though there are other stocks in the study for which the strategy had better results. But the basic problem is that the stocks selected seem unlikely to have been representative of what a conservative to moderate investor would have chosen at the beginning of the study, and thus it's not really possible to draw broad conclusions.

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OK, moving on... The book is now a few years old, and thus misses some recent market changes. There are several funds that now implement buy-write strategies, making it much simpler for investors to access these strategies (I don't *think* the authors mention any of these funds, but it's possible I've forgotten a brief mention somewhere in the book). From my brief inspection of the results of some of these funds, they haven't done very well so far, which bodes ill for individual investors thinking they can implement such a strategy on their own.

Anyways, I've devoted a lot of pixels to picking at the book. In my opinion, it fails to prove that the strategy it advocates is a good one. However, that doesn't mean that the strategy ISN'T good, only that the book fails to prove things one way or the other. But if you're convinced by other evidence that covered call writing is a good strategy, or if you simply want to take your chances (I don't advocate the latter), then the book does at least offer a good overview of the mechanics involved. That's why I give it 3 stars...

This book was by far the most comprehensive on the subject of covered call writing. After reading, I gained a tremendous amount of insight on covered call writing even though I'd tried it before. I now have a better appreciation for the tremendous capabilities of the strategy. I'm not a rocket scientist and even though it seemed this book was designed for the pros, I was able to understand it. In my opinion, money well spent.