Category Archives: Covered calls
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.
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.
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.