This post is based on a comment by Jill:
I have a question about covered calls.
I've owned Verizon (VZ) stock for a while. It has a good dividend and is not very volatile. Recently purchased more when it hit a 2-yr low around $26.15. This stock usually moves up or down a few dollars over a few months. It started trading over $27 and I decided to sell options against it for income, and sold September calls with a $28 strike price.
Shortly after a recent earnings announcement, VZ moved up by > $1.50, and is already above $28.
There are almost 2 months remaining on these options and I'm not sure what I'm supposed to do now. Can I have someone go ahead and buy my stock?
The options are showing a loss but should I close both or do I have to hold them another 2 months? I'd rather get out now if possible but not sure if I can.
(Follow-up comment): Maybe I'm looking at this wrong but my option price is at a loss right now and if I close I'll actually be worse off because of the option – had I not sold calls at all. Right?
For some reason I thought if it reached my stock price I would get the stock gain plus the option income, but I'm actually losing on the stock gain because the option is at a loss. Am I looking at this wrong? Is there any benefit to waiting or do most just close it out when it hits is mark?
You are looking at this correctly, and raised some very good questions. However, you did not fully understand the terms of the contract (options are legal) contracts This is the type of information that beginners must be taught, but almost no one bothers with these details. I bother, and am happy to explain.
Yes, you would lose money on the option if you closed the position. And yes, you would have been better off – this time – by not selling the calls. But do not allow that to bother you. I'm sure you have had success writing covered calls in the past. And you had success with this trade. This is a profitable result. Obviously when you see the current call price, you don't feel that something good happened – but it did. It is not the maximum possible result that could have been achieved, but it is still a good result. Would you be happier if the stock were $27? You shouldn't. The position is worth more at it's current price than it would be at $27.
If you exit the trade by selling your VZ shares and buying those Sep 28 calls, you will have earned far more on the stock that you lost on the calls. Thus, you earned a profit.
This is a concept that is difficult for some people to understand. That is not a knock on their intelligence. It's a psychological thing; it's a mindset that is difficult to overcome.
Once you sold the call, your new position is a covered call. It is no longer only VZ shares. It is VZ shares (at its current price), cash (from selling the options) and an obligation that may require you to sell those shares at $28.
Currently, you are making money on that position. You may not have a profit on each part of the position. However, you have a profit on the total position. You earned more on the stock than you lost on the option. That's a good thing. That's how a risk-reducing hedge is supposed to work. You win on one side and lose on the other. When the win > the loss, you have a profit.
Now, per your question, evaluate alternatives:
a) There is a benefit to waiting. There is also risk. The benefit is collected if and when the option is eventually exercised and you sell your shares at $28. Net cash to you, $2,800 (per covered call)
However, if the stock falls back to 26 (for example), the position would be worth only $2,600.
Thus, the potential benefit comes with risk. That's customary when investing.
b) Most covered call writers do not think about the stock 'hitting its mark.' When you write covered calls, you are doing two things. You collect time premium. Everyone likes that part. You also accept the obligation to sell your shares – but only when the option owner wants to buy the shares.
CC writers think of the stock being above the 'mark' when expiration arrives – not hitting it sooner.
Here is the part that is not understood (or explained to the beginning option trader): You have nothing to say about the timing. The option owner has all the rights associated with the trade. The option seller has only obligations.
The option owner has the option (the choice) of when to exercise. He/she also has the right to decide whether to exercise. There is NOTHING you can do to influence that decision. You have only two choices. Wait or trade out of the covered call position by buying Sep 28 calls and selling stock. Trading out of the position is alternative b).
Nearly all the time, the option owner waits until expiration to make the exercise decision. [On occasion the exercise is made early so the option owner gets the stock in time to collect a dividend]. Thus, included in your obligation to sell shares is the obligation to WAIT until the option owner chooses to exercise. You should assume that will not occur before expiration. [You don't learn of the expiration exercise until Sunday or Monday morning following expiration]
To reiterate your alternatives: You can repurchase now, paying some time premium (i.e., when you buy the call and sell the stock, you cannot collect the full $2,800. If you wait for expiration and IF the stock is above $28, then you get the whole
Consider how much more you can earn; consider how long it will take to earn that money; decide on the likelihood of VZ being above $28 when the market closes on Sep 17, 2010. Considering those things, do you want to exit now – or hold?
If you choose to hold, you get to make that same decision every day from now through Sept expiration. You don't have to do the math every day. The point is you always have the alternative of closing or continuing to hold.
Jill this is a basic, but important concept. If you still have any doubts or follow-up questions, please don't hesitate to ask.
'Hit the target': Ask yourself. Why would anyone buy an option and pay a premium if all that person wants to do is buy stock when it hits the $28 target? That investor would enter a GTC 'buy stop' at $28. That order is to buy shares, but only if and when it trades at $28 or higher. There is no option premium to pay. No option exercise commission to pay. If stock never gets to $28, the investor loses NOTHING. That's much more efficient than buying an option.
I truly hope you can see that no one in his/her right mind would ever do that. The whole purpose for buying an out-of-the-money option is to see the stock rise well above the strike price. The plan is to invest a small amount of cash in the option now, instead of investing a bunch of money by paying for the shares. [This person, speculating on the future price of VZ, will never exercise the option. Instead, he/she hopes to sell it and collect a profit – at some time prior to expiration]
So if the stock does hit the target, it would be foolish in the extreme to exercise. The option owner gets all appreciation above $28, so why exercise and come up with $2,800? No reason. Why take the risk that the stock price will fall? The option owner loses only the value of the option – when stock falls. The exerciser loses any time premium remaining in the value of the option by exercising – and also loses on a stock slide. No one would do that.
I understand why you are asking. This question is not uncommon. But I hope the above explanation makes it clear to you that the option buyer would never exercise when the stock rises to the strike price. There is just nothing to gain and there is a guaranteed loss (time premium in option) plus risk of a substantial additional loss (if stock tumbles).
That's why options cost money. There are advantages to owning them [there are also advantages to selling, but that's not part of this discussion]
Many people anticipate being assigned as soon as stock hits the 'target' or strike price. I hope this explanation makes it clear why that will never happen.
Thus, you either pay that residual time premium now (buy call and sell stock), or wait until September. That's your choice.
I am one of more than a dozen contributors to this book.