The Covered Call. - Own the stock - And Sell the Calls - Mildly Bullish

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Shona Wilkins
5 years ago
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1 The Covered Call - Own the stock - And Sell the Calls - Mildly Bullish

2 Introduction Selling Covered Call is one of the most well known option strategies. Before discussing the mechanics and applications of this strategy, a quick review of basic terms and definitions that relate to call options is in order. Options are contracts between two parties: the buyer of the option, and the seller of the option (also referred to as the writer). Call Option Buyers: A call option gives its buyer the right, but not the obligation, to purchase 100 shares of the underlying stock at a specific price (the option s strike price, also known as its exercise price) at any time until a fixed date in the future (the option s expiration date). Call Option Sellers: The writer of a call option assumes an obligation to sell 100 shares of the underlying stock at the option s exercise price if assigned at any time before the option s expiration. The name Covered Call is derived from the seller of the Call options being Covered as she can fully meet her obligation with the shares already owned. A person who sold a Call Option would be considered Naked as they do not have the stock to deliver. Writing Covered Calls Assume an investor currently holds 600 shares of XYZ, trading at $28. He purchased these shares at a lower price and has determined that $30 represents a fair target price at which he would be more than willing to sell his shares. One alternative is for him to simply wait until XYZ reaches $30 and then sell the stock in the marketplace; a second alternative is to write covered calls. The XYZ February 30 calls (with 55 days until expiration) are trading at $1.20. The investor decides to write 6 of these calls, thereby obligating himself to sell his 600-1

3 share position at $30 if assigned. In other words this investor is writing calls to presell shares he owns at his target price. What are the possible outcomes, the advantages and disadvantages of entering into such a strategy? Share Price Finishes Above Call Strike Price at Expiry First, let s review the possible outcomes: If XYZ rallies and is above $30 at option expiration in 55 days, then in all likelihood the investor would be assigned in the in-themoney written calls and be obligated to sell is 600 shares at $30 per share. Note that the stock could be trading at a price substantially higher and by being forced to sell at $30, this investor would suffer an opportunity loss. But if his goal was to sell the shares at $30, then his goal was met. Share Price finishes below Call Strike Price at Expiry Second, XYZ could be unchanged (or increase slightly) and close below the $30 strike at expiration, with the written calls expiring out-of-the-money and worthless. At this point the investor will still own his XYZ shares, his obligation to sell these will be terminated, he will have realized a $1.20 profit on the calls initial sale. He would then be in a position to sell another series of call options (for example the April 30 calls) if he is still willing to sell his XYZ shares. Share Price falls lower Finally, XYZ could fall in price below $28 over the coming two months. In this case the investor s accrued but unrealized profit on his XYZ would be reduced by the amount of the stock s decline. This loss, however, would be partially offset by the $1.20 gain the investor realizes on the expiring out-of the- money call options. 2

4 Advantages of writing covered calls in this example þ $1.20 per share profit will be realized if XYZ is unchanged over the next 55 days þ If XYZ retreats, the calls offer partial downside protection, reducing the losses on the stock by $1.20. þ This strategy helps an investor stick with a set target price for selling the underlying shares. Some investors may find that writing covered calls on stocks they own helps them with trading discipline and forces them not to constantly change their target prices. Disadvantages of writing Covered Calls in this example þ Downside protection is limited to $1.20 þ Investor may suffer an opportunity loss if XYZ rallies substantially above $30 þ If the investor s opinion on the underlying stock changes, exiting the covered write prior to expiration is more complex than simply selling the shares, as the written options must also be repurchased (covered). Writing Covered Calls as an Alternative to Open Orders Some investors view writing covered calls as an alternative to entering an open sell order. Someone who enters an open sell order for a stock that they own is saying: "If these shares go up to $45, I will sell them". Someone who writes the $45 calls on these same shares is saying: "If these shares go up to $45, I will sell them". But there are subtle differences, as well as many similarities, between these two strategies. Let s look at them in more detail. þ Cash flow: There are no costs in entering an open order but neither are there any tangible benefits. By writing covered calls an investor will pocket the options premium as positive cash flow is generated. 3

5 þ Result if stock unchanged: If the stock is unchanged by the options expiration date, the call writer will have a profit equal to the options premium and will still hold her shares. The investor who placed an open order will still have a long stock position, but neither profit nor gain. þ Result if stock down: If the price of the underlying falls, the investor who placed an open order will be accruing unrealized losses (or seeing her accrued gains diminish); the same situation will exist for the covered writer, except that he will keep the option premium which will fully or partially offset the losses (or reduced profits) on the stock. þ Stock briefly hits target price: Assume an open sell order was placed at $45 by one investor, and the $45 calls written by another. If the stock rallies briefly above $45 the investor who placed the open order will sell his shares (assuming the stock rises to any price above $45). The covered writer may not be assigned on her short calls if the stock rises briefly above $45 and then retreats to a lower level. The odds of selling shares at $45 are therefore better for the investor who places the open order (stock only needs to trade above $45 once) than for the covered writer (stock needs to be above $45 at option expiration). þ Cost of changing one s mind: The investor who places an open order can cancel this order or change the target price at any point in time, at no cost, so long as she does so before her shares have been sold. The covered writer who decides to change his mind, either cancelling his obligation to sell outright, or moving his target selling price higher, will have to re-purchase the calls sold and may be doing so at a profit or at a loss. For the covered writer, it is impossible to tell if there will be a cost associated with changing his mind. So an investor who is considering writing covered calls as an alternative to placing an open sell order for a stock held must weigh the following: receiving the options premium which will lead to out-performance if the stock does not rise to the target price versus the higher probability of selling the stock through 4

6 an open order and the unknown cost of changing one s mind sometime in the future. Will My Short Calls Be Assigned? There may be situations when the covered call writer may not be able to reliable predict whether he is going to be assigned or not at expiration. If on expiration Friday the stock price closes above the strike price of the Short Call Option, the shares will be automatically sold. Early Assignment All equity options are American-style options, which means that their holders (buyers) have the right to exercise them on any business day, up to and including expiration Friday. The flip side of this, is that the writer of an equity option is at risk of being assigned early. Two questions need to be answered: can the risks of early assignment be quantified, and is early assignment a negative or a positive? To quantify the risk of being assigned early on written calls, it is best to view this question from the perspective of the option holder, the investor who purchased call options. Assume an investor purchased some September $50 call options. The underlying stock is now trading in the $54-$55 range. Should this investor exercise his options early? The $50 calls give this investor the right to purchase shares at $50. He could do so today, but he could also do so tomorrow. Is there any advantage in exercising this right today? Not really. Is there any point in waiting until tomorrow? Yes. Assuming that this investor has the cash necessary to purchase the underlying shares, waiting until tomorrow to exercise means postponing the purchase by one day. This means that the 5

7 cash can be retained and earn interest for an additional day. Of course, tomorrow the same analysis can be made again and the purchase deferred another day to earn another day s worth of interest. The option holder has one very good reason to postpone exercising his calls: the longer he waits, the longer his cash earns interest. Therefore, early exercise/assignment of calls is relatively rare as there is no economic justification in spending money today when it can be spent later. Ex Dividend Date & Assignment There is, however, one exception to this, and that is when the underlying stock is about to go ex-dividend. The question facing the call holder is: do I wait until immediately prior to expiration and keep earning interest on my cash, or do I exercise on the day before the stock goes ex-dividend, spend the cash early but collect the dividend? When equity calls are exercised early it is in most instances for a dividend. Call writers should therefore be aware that the risk of early assignment is at its highest immediately prior to the underlying stocks ex-dividend date. But is being assigned early a negative event? The writer of a covered call knows that at best she will sell her stock for the options exercise price. Being assigned early simply means selling the underlying stock earlier rather than later, and at the same price. Most investors would prefer to get paid today rather than tomorrow, and early assignment may be viewed as a positive. 6

8 Buy/Write Strategy If the starting point of the covered call discussion in the previous section was an investor with an existing long stock position looking to cash-out by selling it at a target price, the starting point of this buy/write discussion is an investor looking to invest cash instead. Here is what we mean: the buy/write is the new purchase of underlying shares, and the simultaneous writing of covered call options. For example, an investor could purchase 300 shares of XYZ at $62 and simultaneously write 3 of the June 65 calls at $2.30 per contract. At most brokerage firms, both the purchase of the stock and the sale of the calls can be entered as one order. The buy/write is primarily a return based strategy; that is to say investors enter into it looking to earn a specific rate of return. Most investors who establish a buy/write calculate two rates of returns before entering into the strategy: 1. static return 2. if-called return Calculating the initial investment The premium received when call options are written can be used to partially pay for the purchase of the underlying shares. For example, an investor who purchases shares of XYZ at $28 and simultaneously writes the December 30 calls at $1.10 can use this $1.10 to partially pay for his shares. His initial investment is therefore only $26.90 (i.e., $28 less $1.10) per XYZ share. This is the cash that would be necessary to initiate the buy/write and represents the investor s initial investment. This also represents the downside break-even on the overall strategy, i.e., the buy/write will show a loss at option expiration if XYZ falls below $

9 Calculating the static return The static return answers the question: What will the strategy s return be if the price of the underlying stock remains unchanged? For example, an investor purchases XYZ at $57 and writes the August 60 calls at $1.70. August options have 70 days until they expire. What will be this investor s static return? The profit on the strategy, assuming an unchanged stock price, will be $1.70, the option s premium. Remember that if the price of the stock remains unchanged the calls will expire worthless as they will be out-of-the-money. The investor will still hold the shares of XYZ (still worth $57) and will have a gain of $1.70 on the expiring options. The static return will therefore be: $1.70 profit / ($57 - $1.70) cost of shares = 3.07% It is customary to annualize returns calculated for buy/writes. This is done by dividing the actual return by the number of days until expiration and multiplying by 365: (3.07% X 365) / 70 = 16.0% annualized If the stock pays a dividend and if the investor is entitled to receive one or more dividends over the term of the strategy, then the dividends received should be added to the strategy s profit. Calculating the if-called return The if-called return answers the question: What will the strategy s return be if the underlying stock rises above the options exercise price, the calls are assigned and the stock sold at the options strike price? The if-called return also represents the strategy s best-case scenario, the maximum return that can be realized. In dollar terms, the most that a buy/write can earn is the appreciation of the stock from its purchase price to the options exercise price (assuming that the calls written were out-of-the-money) plus the option premium obtained in initiating the strategy. 8

10 Continuing with the same example used in calculating the static return, if XYZ is purchased at $57 and the August 60 calls written for $1.70, the stock s potential appreciation is $3 (from a purchase price of $57 to the options exercise price of 60) and the options premium remains $1.70. The if-called return is then: ($3 + $1.70) / ($57 - $1.70) = 8.5% Once again, it is customary to annualize this return, with the same formula used with the static return: (8.5% X 365) / 70 = 44.3% annualized As with the static return any dividends that accrue to the investor during the lifetime of the option should be added to the investor s profit. A note of caution: some buy/writes will post eye-popping if-called returns. Investors must remember two facts when looking at these returns: 1. the if-called return will only be earned if the underlying stock rises above the options exercise price by the expiration date. This may represent a substantial rise in a short period of time. 2. an investor may not be able to realize the annualized returns based on relatively short periods of time (such as 70 days in our scenario above) on a consistent basis. If the buy/write in our example does earn its 44.3% annualized rate of return, there is no guarantee that in 70 days another comparable buy/write with a comparable rate of return will be available. When to apply a covered call strategy A buy/write is most appropriately defined as a neutral to moderately bullish investment strategy. This means it will perform best using stocks that are expected to remain unchanged ( neutral ) or rise slightly ( moderately bullish ). If a stock is 9

11 expected to rise substantially a more bullish strategy may be in order, although the buy/write will remain profitable if the underlying stock rallies strongly. Comparing Different Buy/Writes for a Specific Stock An investor has decided to initiate a buy/write on XYZ stock, currently trading at $125. She is considering writing either the March 130 calls at $2, or the March 135 calls at $0.90. March options expire in 60 days. She calculates the following annualized static and if-called returns for these two options: $130 Calls $135 Calls Static Return 9.9% 4.4% If-Called Return 34.6% 53.4% She notes that the 130 calls offer the higher static return and the 135 calls the higher ifcalled return. Is one buy/write better than the other? No. And herein lies one of the decisions every investor who initiates a buy/write must make: which strike price should be chosen. A few points to keep in mind when deciding between various strike prices: 1. There is a greater probability of earning the static return than of earning the ifcalled return, since the former only requires the underlying stock to remain unchanged, whereas the latter needs the stock to rise to the options exercise price. 2. When comparing two options, the at-the-money (or the one closest to being atthe-money) will have a higher static return, the out-of-the-money the higher ifcalled return. 10

12 3. The further a call is out-of-the-money, the greater the proportion of the potential return that comes from stock appreciation, and the more the position starts to look like a straight stock position. There is unfortunately no best option that can be written, just choices between higher static and higher if-called returns. Comparing Buy/Writes on Two Different Stocks An investor is looking to initiate a buy/write and has narrowed her choice to two stocks: XYZ and ZYX. She calculates static and if-called returns with the November options (72 days until expiration) and obtains the following annualized numbers: XYZ ZYX Static Return 5.1% 7.4% If-Called Return 21.2% 29.9% At first glance ZYX would appear to be a better choice: it offers both a higher static and a higher if-called rate of return. But there is a reason that both rates of return are higher for ZYX: the options premiums are higher, indicating that the market is pricing these with a higher volatility estimate. In other words, the options on ZYX are relatively higher because the market views ZYX as a more volatile, and therefore more risky, stock. The covered write on ZYX is not better than the one on XYZ it simply offers a different risk profile: higher potential return for taking on a higher level of risk. As a rule of thumb, abnormally high rates of return generally come with higher degrees of risk. 11

13 Whenever investors find buy/writes with abnormally high rates of return they must realize that these come at the cost of assuming a higher degree of risk. Buy/Writes: Possible Outcomes at Expiration If an investor has initiated a buy/write and takes no action prior to option expiration, there are only two possible outcomes: the calls will either expire worthless, or the investor will be assigned and the underlying stock sold at the options expiration price. (In the next section we will explore possible actions to be taken prior to expiration). 1. Stock above options exercise price: If on expiration Friday the stock closes above the options exercise price, it is more than likely that the options will be assigned and the investor who initiated the buy/write will be forced to sell the underlying shares at the options strike price. The strategy will then have earned its if-called return, the highest return it can generate. 2. Stock below the options exercise price: If on expiration Friday the stock is below the options exercise price, the options will expire worthless and the writer s obligation will be terminated. On the Monday following expiration the investor will then have the opportunity to write another series of call options. For example if the June options ceased trading on Friday the 18th, on Monday the 21st an investor could write July or August options if she wanted to continue with the buy/write strategy. If the underlying stock is unchanged or close to unchanged, calls with the same strike price as the June options can probably be written. If the stock is down by more than a few dollars, the investor who wants to continue writing covered calls may have to select a lower strike price than that of the June options, a situation that could eventually produce a loss. For example assume the stock was originally purchased at $43, and the June 45 calls sold for $1. If at the June expiration the stock is trading down at $38 the June calls would expire with no value. On Monday after expiration July 40 calls could be sold for 12

14 $1. Since the investor s initial investment was $42 ($43 initially paid for the stock less the $1 premium received from the sale of the June calls), writing the July 40 calls reduces this by another $1 to $41. If the stock is above $40 at July expiration and the investor is assigned on the short July 40 calls, the net loss on the strategy would be $1 per share since a total of $41 was invested but only $40 generated on the sale of the stock from the assignment. Some investors may not want to write the 40 calls since they are locking in a loss, others may be willing to do so since absorbing losses is part of investing. Timing is the key to covered call writing Trying to write calls for income and not have your stock called away from you takes a bit more skill and timing. It is wise to recognize the bearish or neutral price patterns that you have learned previously to help recognize when a stock is most likely to relax, thus allowing us to keep our premium and our stock, with the anticipation of doing it again next month. It is during the peaks of these patterns that we should look to sell calls. 13

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1 2 3 4 5 6 7 8 9 Who Should Consider Using Covered Calls? An investor who is neutral to moderately bullish on some of the equities in his portfolio. An investor who is willing to limit his upside potential