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Covered calls give up the upside
How the trade works
The setup starts with owning a stock. The owner sells someone else a call option, the right to buy the stock at a preset price, and collects a premium for it. If the stock rises far enough, the owner has to hand it over at the preset price. With the stock at $40 and a call sold at $50, a climb to $60 still means selling at $50, which gives up a big chunk of the upside.
Why it sells
The product sells well because of a bias for income. Mental accounting makes investors separate capital from income, so income feels like a separate prize. Covered call ETFs have proliferated, they usually charge a higher fee, and they are marketed on the promise of both capital appreciation and income.
The implied cost of giving up that upside is enormous, and most investors do not realize how much they are giving up.
Why do investors prize income over capital?
In a 1984 paper, Hersh Shefrin and Meir Statman argued that investors treat dividends as spendable income and price changes as capital that should not be touched. Under mental accounting, a dollar of income and a dollar of capital gain feel different even though they are worth the same. Richard Thaler, who developed the idea of mental accounting, won the 2017 Nobel Prize in economics.
How does a call option's premium get set?
The Black-Scholes model, published by Fischer Black and Myron Scholes in 1973, prices an option from the stock price, the strike, the time to expiry, interest rates, and volatility. Higher volatility raises the premium, because a bigger swing makes the right to buy more likely to pay off. Robert Merton extended the work, and Merton and Scholes received the 1997 Nobel Prize in economics.
Why did listed options only start in 1973?
Before 1973, options traded over the counter with customized terms and no central clearing. The Chicago Board Options Exchange opened on April 26, 1973, listing standardized calls on 16 stocks. Standard contracts and a clearing house made them easy to trade.
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