Covered Call – Key Points About Selling Options Part 6

Covered Call – Key Points About Selling Options Part 6

 

Covered Call – Key Points About Selling Options (Part 6)

 

So, here’s the strategies, the simple strategies that I will walk through. First the covered call. Now I said in the beginning, it’s very rare if ever do I speak to a investor who is selling naked call options as some people do that, but it’s very rare. Most often selling a call option is done when the investor owns shares of stock. And in that case, long stock selling a call option would serve as almost like a limit order to sell their stock at the strike price. The motivation for selling a call instead of using a limit order is to get additional income and premium in the form of selling the option. If the stock doesn’t move, if it drifts very, very slowly higher or lower, that premium can be kept, and the investor can continue to sell options moving forward at different expiration dates. Now a couple things about this,

let’s go through what ifs. Certainly, the risk in this position is if the stock moves lower. You own stock, you have a bit of a buffer to the downside in the amount of the premium that you receive from the call option, but that’s it. You stand to lose if the stock moves lower and especially if it moves lower considerably, so to the downside you’re managing your risk tolerance. How much can I afford to give back? And when do I need to get out of this trade? One important thing to note, since most accounts don’t have approval to hold a naked short call option position, if you do see the stock trending lower and you want to get out of this thing and you say okay the call option premium give me a little bit of an added buffer, but I’m done with this trade. Undoubtedly, you will have to exit both the stock in the call either at the same time or buy the call option back first, and then sell the stock.

This always comes to my mind because I was in the futures business back in 2010 when gold was trading at crazy levels, and the volatility was absurd, and I was working with a plenty of clients that had long futures positions in gold and short calls. And on days when the market was down heavy, in the futures markets are very leveraged, on days when the market was down by a large amounts these investors were trying to get out of their futures contracts and getting trades rejected because they had open short call positions that would have been exposed. They had to close those calls first, and when you’re in a panic situation which is what happens when the market crashes, you might not be thinking clearly. And a lot of clients at our desk were not, and they were confused about having rejected orders and watching their accounts get blown up in minutes and trying to frantically decide what was going on not realizing what they were doing. They own the futures and were confused. Why can’t I sell them? Well, you have short calls and exposing them with something they didn’t have permission to do. So, be careful if you’re getting out to the downside.

Now if the stock doesn’t go anywhere you have a covered call position, stocks at $65 you sold the $70 strike call option. Nothing happens stock doesn’t move. That’s okay. You made a little bit of money on the calls you didn’t waste your time on it. A lot of investors will say well, I’m just going to sell it again. I’m going to sell them every week or every month and keep doing it over and over and over again. It really is a good strategy to consider. What I always caution investors is don’t fall into a habit of blindly doing something over and over and over again without re-evaluating. Make sure that if it worked yesterday, and it works today, it might not work tomorrow. So, re-evaluate, make sure it’s still the position you want and it’s still the exposure that you want to have and then decide what you want to do. Maybe circumstances have changed, don’t want to do the covered call at all. Maybe you are bearish, and you want to get out. Maybe you’re more bullish and don’t want to sell a call option or maybe you want to sell a different one. So just re-evaluate and then reapply.

Now, things get more interesting from my perspective, is if the stock moves higher. One thing I hear from investors with this position is, and I have a covered call position, my great trades, my best stock positions get called away and I find it frustrating and I understand how that works. And there’s a couple things there, first of all active position management can prevent that. You can watch the stock move and if you really think the stocks moving higher buy back the option. If you were extremely bullish you would have never sold it in the first place. So, it’s not the fault of the strategy. It was the fault of your market analysis. You didn’t think it was going to blow up to the upside. So, you sold the call option and that’s where the problem occurred. But, something else, a few other things – you can choose variations of selling covered calls and this comes into play when you have a fairly large position.

Frequently, we find ourselves not just trading with 100 shares, but maybe 300, 500 or a thousand shares. In that case, you can do a number of things. You can sell fewer calls than the stock you own, maybe three, five, or eight depending on how aggressive you want to be. So, if you do get that blow to the upside, you’re not called out of all of your shares and you can capitalize on a run higher on a certain portion of your position. You can also stagger your strikes. Say, well look I’m going to effectively scale out of this position two percent higher. I’ll sell 30% of it and if it goes up another two percent from there, I’ll sell another 30%. And you can sell higher strike prices, certainly for lower premium amounts as you go up, but scale out of your position so that if you get out of the whole thing, you’re very happy with the result of the trade. While doing that you can also stagger expiration dates. Go up in strike price gradually and go out in expiration date, that will actually allow you to capture more option premium if you’re selling options that are say 6, 8 or 10 percent out of the money, you can go further out in time to get to get greater premium. Number of things you can do there.

Last thing I’ll say about the covered call on the upside is that there is a circumstance where you would likely be influenced to just exit the entire trade, where it becomes all risk and no reward. Reflecting back on what we just covered regarding moneyness and time values. What I said in the beginning, when you sell an option you are trying to capture the premium associated with the options contract specifically the time value. In this case, for the covered call we’re trying to capture time value. When the time value goes to zero, there’s nothing left to gain on the covered call. If the stock is above the strike price and the time value is 0, there’s nothing possible that you can gain further on the position. In that case, when it’s all risk, no reward that’s a time to consider just exiting and moving on to the next trade.

A quick example with numbers on that, same ones as before. The stocks at $65. We sell the $70 strike call option, doesn’t matter what we sold it for, stock moves up to 75. We’ve made all we could on the stock itself from $65 up to $70. Now, the stock is up five dollars above our strike price, five dollars in the money. If we look on our options chain, and we see the option trading for $5, that means there’s no time value left. There’s nothing left for us to get out of this position. Usually a good time to consider exiting and moving on. Now if the options trading for six dollars, or six and a half dollars, you have something to consider. There’s another dollar or dollar and a half that you can further gain from the erosion of the time value from one day to the next. All the while, if you try to capture that or under the risk of the stock turning and moving against you. But keeping in mind how to calculate intrinsic and time value and then managing the position appropriately is very useful. That’s enough on the covered call.