MoneyWatch A call option contract gives the holder the right, but not the obligation, to buy a security at a predetermined price the strike price on a specific date European call or during a specific period American call. A call is "in the money" when the current price of the stock is trading above the strike price and "out of the money" when the reverse is true. Many investors buy call options as part of their investment strategy. Unfortunately, it's likely they do so without knowing the returns to such a strategy. This is an all-too-common problem that isn't limited to options trading -- individuals don't know the returns on their investments. For example, the authors of the study "Why Inexperienced Investors Do Not Learn: They Don't Know Their Past Portfolio Performance" found that not only do individual investors dramatically overstate their performance, but performance is negatively related with the absolute difference between return estimates and realized returns. In other words, the lower the returns, the worse investors were when judging their realized returns. They noted that while just 5 percent of investors believed they had experienced negative returns, the reality was that 25 percent did so! With this in mind, Ryan McKeon, the author of the study "Returns from Trading Call Options," analyzed the performance of a strategy of buying calls. He used the bid-offer spreads to take into account trading costs though commissions and other fees were not considered. This is important not so much because the spread is wide, but because the spread can be wide compared to the price of the option. The following is a summary of his findings:. These findings are consistent with studies that show that individuals are risk seekers in that they have a preference for investments that have lottery-like distributions such as "penny stocks," stocks in bankruptcy, IPOs and small growth stocks. They produce very poor results on average, but on rare occasions they provide outsized returns. The other explanation is that investors don't realize how bad such strategies are in terms of expected returns. If you've been buying call options, you no longer have that excuse. The poor results of a buying calls strategy raises the question about the results of the other side of the trade -- selling calls and earning the premium. There are many investors who engage in this strategy by selling what is referred to as covered calls. A covered-call strategy requires the investor to write sell a call option on stocks that are in the portfolio. Essentially, the covered-call investor is trading off the upside potential above the strike price of the equity investment for an up-front fee and reduced by the size of the call premium exposure to downside risk. Marketers of covered-call strategies demonstrate the efficiency of the strategy through the "Sharpe ratio," a measure of the return earned above the rate of return on riskless short-term U. Treasury bills relative to the risk taken, with risk being measured by the standard deviation of returns. While the Sharpe ratio is a useful risk-reward measurement tool, it defines standard deviation as the measure of risk. While standard deviation does measure the volatility of returns, volatility is not the only measure of risk. Investors care not only about volatility, but also about other characteristics of the distribution of returns, such as skewness. Skewness measures the asymmetry of a distribution. Negative skewness occurs when the values to the left for less than the mean are fewer call farther from the mean than are values to the right of the mean. For example, the return series of percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than zero percent, and three higher; but the one that is negative options much further from zero than the positive ones. Positive skewness occurs for the values to the right of more than the mean are fewer but farther from the mean than are values to the left of the mean. As we have already mentioned, the evidence suggests that investors prefer assets with positive skewness, like the lottery ticket. They generally try to avoid assets with negative skewness. This leads us to the question of what impact does a covered-call writing strategy have on the potential distribution of returns. Does it shift the distribution away from a normal one, rendering the use of measures such as the Sharpe ratio less meaningful? The study, "Covered Calls: For example, using a strategy of one-month covered calls produced a negative skewness of for. The negative skewness calls into question the relevance of the Sharpe ratio for this strategy. While it is true that a covered-call strategy does reduce kurtosis "fat tails"the problem is that it eliminates the potential for the good fat tail the one to the rightwhile having no impact on the risk of the bad fat tail the one to the left occurring. Risk-averse investors would much prefer to eliminate the risk of strategies left fat tail bear market while accepting a smaller right fat tail bull market. Unfortunately, there are other negative features of covered-call writing strategies which include tax inefficiency and high transactions costs. As an alternative, I recommend investors consider lowering their equity allocation while increasing their exposure to small and value stocks. Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately options those of the firm. Find out what activities and attractions make these 20 cities and town some of the best places to retire around the world. Generics are a great way to save money in lots of cases, but here is a look at some clear exceptions. Quotes delayed at least 15 minutes. Market data provided by Interactive Data. Powered and implemented by Interactive Data Managed Solutions News provided by The Associated Press. CBS News CBS Evening News CBS This Morning 48 Hours 60 Minutes Sunday Morning Face The Nation CBSN. Log In Join CBSNews. By Larry Swedroe MoneyWatch August 9,7: Comment Share Tweet Stumble Email. You make the call Many investors buy call options as part of their investment strategy. Do your municipals math Passive investors sow seeds of their own demise The lies active managers tell With this in mind, Ryan McKeon, the author of the study "Returns from Trading Call Options," analyzed the performance of a strategy of buying calls. The following is a summary of his options Call option returns are generally low and decrease as the strike price increases. Deep in-the-money calls generally deliver positive returns strategies held for a month, while all other calls deliver returns that are negative or not statistically significant from zero. Deep out-of-the-money calls deliver lottery-like returns -- very large losses on average, with occasional, but rare, large and positive returns. Of the options that fell into this category, expired worthless, with the average return being percent. The three that did produce a profit provided returns of 1, percent, 2, percent and 2, percent. Such returns provide the hope that leads to mostly very poor results. The holding period didn't matter. Covered Calls A covered-call strategy requires the investor to write sell a call option on stocks that are in the portfolio. Trim the fat While it is true that a covered-call strategy does reduce kurtosis "fat tails"the problem call that it eliminates the potential for the good call tail the one to the rightwhile having no impact on the risk of the bad fat tail the one to the left occurring. Featured in Moneywatch 20 of the coolest places to retire in the world Find out what activities and attractions make these strategies cities and town some of the best places to retire around the world 10 products you should never buy generic Generics are a great way to save money in lots of cases, but here is a look at some clear exceptions. For Illinois, no budget means no Powerball or Mega Millions. Nestle may exit the U. Will the threat of sharks hurt California businesses? Moneywatch Spotlight 10 homes with incredible vertical gardens. New Fire TV App. Company fundamental data provided by Zacks. 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Seeking a balance between work and personal life is a challenge that seems to extend across the many years of a career, regardless of where that career is spent.
Seeking a balance between work and personal life is a challenge that seems to extend across the many years of a career, regardless of where that career is spent.
My heart reaches out to him and his wife, as he is trapped here in Ca. to try to get the charge of grand theft dismissed, as he is innocent of this.