Category Archives: Covered calls

Covered Calls ~ Managing the Trade

If you’re thinking about using covered calls for income, you’ll want to consider how you’re going to manage your trades from the time you establish them until option expiration.

If you already hold the underlying stock or ETF, you’ll it’s only a matter of selecting the strike price and expiration of the call option that you wish to sell and entering your order. When you enter the order you are faced with the decision of what order type to use. When selling calls most traders will choose between a market and a limit order. You may have read elsewhere that you should only use a limit order when trading options. I don’t agree with that and have found that I get excellent executions with market orders as long as the stock is a very liquid penny pilot issue. The most liquid ETFs have excellent execution on market orders and there are times when a market order is better, such as a rapidly falling price, where you’d if your limit wasn’t going to get hit, you’d have to go through the process of canceling and replacing and if the underlying has fallen you’ll have to settle for a lower price than you would have with a market order. If the stock or ETF that you’re selling the call option on is not very liquid and has wide bid ask spreads, don’t use a market order, use a limit and place it about halfway between the bid and the ask then give it time to get filled. The thinner the trading is, the more patient you have to be with the order getting filled.

If you don’t already own the position in the underlying you have some more choices. One choice is to sell a cash secured put, then wait until you get assigned and begin the call writing process. Another choice is to use a buy write ticket. With a buy-write ticket, you enter a simultaneous order to buy the stock and sell the call option at a net debit. So, if the stock is trading at $25 and the option is selling for $1, you’d enter an order for a net debit of $24. You can also use market orders with buy-write tickets and they’ll work as long as the underlying is very liquid. If the underlying is not very liquid and has wide spreads, use a limit order for sure.  If you don’t want to use a buy write, then first you purchase the underlying security, then sell the call option. If you like to trade a little bit, to try to enhance returns, you can leg into the position, by buying the stock, letting it run up, and then selling the call if the stock begins to drop.

Once you have a covered call position established two things can happen at expiration, either the price of the underlying is above or below the strike price, you either get called or the option expires worthless. If you’re option is in the money prior to expiration and you decide you want to keep the stock, you’ll have to buy the calls back, then sell more at another expiration date. If you roll the calls for a credit, that is you sell them to open for more than you bought to close, you can keep rolling them until they expire worthless and generate a profit. You’ll also need to watch out for your dividend ex-dates. If your option is in the money prior to the ex-date and the expiration date is close by, there is a very high probability that you’ll get called. If you want to hold the stock and collect the dividend, you’ll need to roll for a credit prior to the dividend ex-date instead of waiting for the expiration date. If you decide you want to sell the stock prior to the call option expiring you’ll probably want to buy the option back, and then sell the stock. Depending on your level of option approval at your brokerage, you may have to buy the call back first. If your approval level is high enough for naked calls you’ll need to consider if you want to assume the risk of an uncovered call position.

Have a follow up plan in place before you open the position. Know your dividend dates and manage your positions accordingly.

Special Dividends and Option Contract Adjustments

There are times when option contracts are adjusted for corporate events like stock splits or special dividends.  In the case of a 2-1 stock split for example, the option contract strike price is adjusted in half and the number of contracts doubled.

There is no contract adjustment for ordinary dividends. Regular dividends that are paid on a quarterly basis are factored into the option’s price. When a stock goes ex-dividend the stock’s price is adjusted by the amount of the dividend. The call and put option’s price reflects the amount of the dividend.

Due to the ongoing fiscal cliff negotiations, many companies are opting to pay out special dividends this year before the anticipated increase in the dividend tax rate. Currently dividends get a special tax rate of 15%. That rate could go as high as 39.6% in 2013 depending on the outcome of the fiscal cliff negotiations. Campbell soup became the last major company to declare a special dividend. Over 100 companies with a market cap greater than $240 million have declared special dividends this year. The total value of all the dividends is almost $23 billion.

If you’re using a covered call or a collar strategy to collect dividends, remember that with these special dividends, the strike price will be adjusted downward to reflect the special dividend unlike the ordinary dividend.

Option Chain for Boise showing Strikes reduced by $0.72 foe dividend.

Option Chain for Boise showing Strikes reduced by $0.72 for dividend.

Pin Risk at Option Expiration

Pin Risk

Pin risk is a term that is understood by professional options traders, but generally not very well understood by the investing public. Covered call writing is the most basic of all option strategies and is widely used by many investors. It has been proven that covered call writing can reduce risk and enhance return in a portfolio. In today’s low interest rate environment, more and more investors are turning to covered call writing as a way to produce some needed income from a retirement account.

When a covered call is written there are two scenarios that can unfold at option expiration. One is that the underlying stock or ETF will be above the call option strike price and the stock will get called away. The other scenario is that the price of the underlying stock is below the strike price of the call option and the call option will expire worthless.

So, what happens if you are very close to option expiration and the underlying stock is right at the strike price? The answer is that you can’t be sure whether or not the stock will get called away. It’s not an issue if you don’t care whether the stock gets called or not. It can be a major problem if you want to get called and don’t. For example say you bought 100 shares of ABC at $45 and sold the $50 call for $1. The stock is over $50 on the last trading day prior to expiration and this is a situation where you want the shares called away from you. You either need the capital for another investment, or no longer want the stock in your portfolio due to deteriorating fundamentals or technical analysis. With 30 minutes to go on the Friday before expiration, the stock is at $50.05, it looks like you should get it called, but what happens if the stock settles right at $50 or moves below in the final seconds of trading? You may end up holding a stock that you wanted to get rid of. You could think that the stock was going to get called and find out on Monday morning that you still own it and that it has gapped down at the open creating a substantial loss.

The best way to eliminate pin risk is to close out positions on the last trading day before option expiration to be sure that you have the result you want. Buy back the calls for a few cents and sell the stock in the open market if you want it called away.

The same thing applies to any other short position, like puts, spreads, etc. Close the position if the underlying is very close to the option strike price near expiration if the unexpected option assignment or lack of an assignment will create problems for you.

Delta Neutral Call Option Writing

Advanced Call Writing Strategies

Delta Neutral Call Writing

Much has been written about the popular covered call writing strategy, where an investor will purchase 100 shares of a stock or an ETF and sell one call option for some income and partial downside protection. The term covered call means that for every option you sell that option contract is covered by 100 shares of the underlying investment.

Advanced option traders will be familiar with the term delta neutral. For those readers who are not familiar, the term means that your position is delta neutral, it has no market directional bias, in other words the position is neutral to market movement.  So, if we buy 100 shares of XYZ stock, that position alone will have a delta of 100, now if we sell an at the money call with a delta of 50, because we are short the call it will have a negative delta, so the net position delta will be 50, 100 deltas for the 100 shares of XYZ stock and -50 deltas for the short XYZ call. This is how your typical covered call position works. If you were to sell an out of the money call with a delta of 25 your net position delta would be 75, in other words the total position would behave like 75 shares of the underlying instead of 100.

Now, if we want to create a market neutral position, we’ll sell enough calls so that the net position is delta neutral. So, if we buy 100 shares of XYZ again we could sell two 50 delta at the money calls, three 33 delta out of the money calls, or four 25 delta out of the money calls and so on. If the net position delta is at or near zero, your position will not have directional risk as long as it remains delta neutral. Then you can earn the theta or the decay from the short options. You don’t have to sell the options at just one strike price, either. For example you could sell one at the money 5o delta call and two out of the money 25 delta calls.

Once a position is established, the delta will change by the rate of the gamma, and adjustments will have to be made to remain delta neutral. You can adjust the shares of stock you own, sell more calls, or buy some calls back to make the delta neutral adjustment.

As with any strategy there are risks, the underlying can drop rapidly before you can adjust and you can experience a loss. Since you have uncovered short calls, if the underlying explodes upward rapidly you can also experience a substantial loss. Stocks that have high volatility or may be potential takeover targets should be avoided. Mega cap stocks can be good candidates or broad based index ETFs can be good candidates for a delta neutral strategy. Indexes can rise and fall rapidly, but they have never dropped all the way to zero like individual equities can or explode upwards the stocks getting taken over can.

Looking at some current prices as of this writing, the SPY is at $131.82 and the Feb 135 calls are 21 days from expiration. The Feb 135 calls sell for $0.61 and have a delta of 24. You could sell 4 of those calls against a 100 share position of SPY and take in $2.44 in premium, the theta is -0.03 so you’d be getting $12 per day in decay. You could make delta neutral adjustments as time goes by on a regular basis, but you wouldn’t have to worry about loss unless the SPY rises to above 135 by expiration. This is not a recommendation for the above SPY trade, I like using some real numbers for illustrative purposes, this is a strategy for sophisticated investors who understand the risks and are familiar with options and making delta neutral adjustments.

The Covered Call – How to Sell a Call

The covered call is one of the most common option market strategies employed by individual investors. The call writing strategy can lower risk and produce income at the same time. The investor will sell a call on her stock position for immediate income. The call money shows up in the account right away. The covered call writer is moderately bullish to neutral in her market opinion and is willing to sacrifice some upside gain in order to collect the premium from the sale of the call contract. The risk of the underlying stock position is reduced by the amount of the call premium or call money received. Call premium from the short call is received into the investors account as immediate income. For example an investor may buy 100 shares XYZ stock at $25.00 and subsequently sell 1 October $30 call at $1.25.  At expiration if XYZ is above $30, the investor will have the stock called away.  When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and the call premium of $1.25. Her cost basis in the stock is now also reduced to $23.75, the initial price of the stock minus the premium received for the call.

Numerous academic studies have been done on the covered call strategy also known as the buy write strategy and one of the conclusions drawn from them is that covered call writing can not only enhance portfolio return, but the strategy has been shown to provide those returns with lower risk. The portfolio volatility  can be significantly reduced by employing a covered call writing strategy. Since the delta of an at the money option is 50 and the delta of the underlying fund is 100, if an investor sells an at the money option, the position delta is reduced to 50, so that position has about half the risk of the underlying position as long as the option stays at the money, as long as the price of the underlying does not move very much. Another Greek that the covered call writer wants to monitor closely is the theta, or rate of decay. The theta tells the option writer how much money she’ll earn daily just through price erosion. At the money options will have the highest theta. Shorter term option contracts will  have a higher theta than loner term option contracts.

Say for example that an investor sells a slightly out of the money option for $2 at the beginning of the month, not the first calendar day of the month, but the first Monday following the third Saturday of the month. If the underlying price stays steady or declines slightly in the last week of the option’s life it may be only worth 5 cents. Since the option’s theta is now only 5 cents and the investor has already earned $1.95 in profit, it may make sense to buy that option back and sell the following months slightly out of the money option and try to increase the theta of the holding. In other words attempt to increase the daily income earned through option decay. Calls can be written on index options as well as on individual stocks and that is a good way to lower risk by avoiding what is known as company specific risk.

Profit Loss Graph for a Covered Call

SPY Covered Call P/L Graph

The Covered Call

The covered call is one of the most common strategies employed
by individual investors. The covered call writer is moderately bullish to
neutral in his market opinion and is willing to sacrifice some upside gain in
order to collect the premium from the sale of the call contract. The risk of
the underlying stock position is reduced by the amount of the call premium
received. Call premium is received into the investors account as immediate
income. For example an investor may buy 100 shares XYZ stock at $25.00 and
subsequently sell 1 October $30 call at $1.25. At expiration if XYZ is above $30, the investor will have the stock
called away.  When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and
the call premium of $1.25. Her cost basis in the stock is now also reduced to
$23.75, the initial price of the stock minus the premium received for the call.
Numerous academic studies have been done on the covered call strategy and one
of the conclusions drawn from them is that covered call writing can not only
enhance portfolio return, but the strategy has been shown to provide those
returns with lower risk. The volatility of the underlying fund or stock can be
significantly reduced by employing a covered call writing strategy. Since the
delta of an at the money option is 50 and the delta of the underlying fund is
100, if an investor sells an at the money option, the position delta is reduced
to 50, so that position has about half the risk of the underlying position as
long as the option stays at the money, as long as the price of the underlying
does not move very much. Another Greek that the covered call writer wants to
monitor closely is the theta, or rate of decay. The theta tells the option
writer how much money she’ll earn daily just through price erosion. At the
money options will have the highest theta.  Say for example that an investor sells a
slightly out of the money option for $2 at the beginning of the month, not the
first calendar day of the month, but the first Monday following the third
Saturday of the month. If the underlying price stays steady or declines
slightly in the last week of the option’s life it may be only worth 5 cents.
Since the option’s theta is now only 5 cents and the investor has already
earned $1.95 in profit, it may make sense to buy that option back and sell the
following months slightly out of the money option and try to increase the theta
of the holding. In other words attempt to increase the daily income earned
through option decay.