Covered Call Confusion

Money Hacks Carnival # 70 went live today and one of my posts was used.  The carnival includes articles on a wide variety of money/banking/finance issues.

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A series of questions from a rookie options trader outlines some problems with understanding how the writing of covered calls works.


1) When I sell a covered call and, at a later date, purchase the
same number of covered calls (same strike and expiration as I
sold), is it the brokerage that keeps track of the fact that the stocks
are no longer obligated (assuming no assignment has taken place)? 

The definition of a covered call is a call option that is written (sold) when the writer owns enough shares to make delivery (sell), if assigned an exercise notice.  Thus, by definition, you cannot 'buy covered calls.'  You can sell covered calls, and you can buy back those calls (to close), but they are not called covered calls when you buy them.

No.  It's the OCC – that's the Options Clearing
Corporation – that keeps records of the options – who owns them and who is short.  The broker must keep a record of whether you are long stock when you sell calls – but only to enable them to be certain you are allowed to sell the calls and to calculate the margin requirement for the position.  Some brokers do not allow the sale of uncovered calls. The broker's computer instantly recognizes whether the stock is 'obligated.'  You can sell that stock only when a) your broker allows you to carry a naked short call position and b) when you can meet the margin requirement that selling stock will inflict upon your account.  Otherwise you must maintain ownership of those 'obligated' shares.


2) If I purchase the calls as in question 1 and my stocks, are
therefore covered…

That's the wrong
word.  Call options are 'covered'  when
you sell that option and own enough shares to deliver – if assigned an
exercise notice.  Stocks are neither covered nor uncovered.  You just own them.

One day you are short those calls and you buy them in the open market.  The next day your account shows
no position in that specific option.  No position means
you can no longer be assigned an exercise notice and thus, are under no
further obligation.  NOTE:  If you buy the options on a given day –
there is no chance you will be assigned an exercise notice that night. 
In other words, those assignment notices are not delivered during the trading
day.  They are delivered overnight to some – randomly selected –
account that still has a short position (after the day's trading has ended) in the option that was
exercised by its owner.


how long to I have to keep ownership of the calls I
purchased?  It seems that I would have to hold them through expiration?


You do NOT own them.  If you buy stock
and then sell it, you have no remaining position.  Options work the
same way.  If you sell options and then buy them back, you have no
position.  Be certain that you understand this.  It's important.  No
position. 

Thus, you cannot 'keep' them.  The important thing for you to know is that by closing your short option position (that simply means buying the options you sold earlier) you are no longer under any obligation to sell your shares.  You cannot be assigned an exercise notice.  Nor can you pass 'Go' and collect $200.

These probably seem like such basic a trivial questions to an
expert such as yourself.  I really appreciate your help.



The problem is that too many beginners think stuff
is just too trivial, refuse to ask questions, and then get into trouble.  It's a very
good idea to get your questions answered before you invest with real money.  You want to
understand what you are doing when using options (or anything else).  When it comes to procedural question like yours, after you have been through the process one or two times, it's much easier to see how it works.

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3 Responses to Covered Call Confusion

  1. arun bhatia 01/11/2012 at 10:31 AM #

    Dear Sir:

    your article was very clear. how does one show an entry while filing the form d

    say you sold 10 covered calls on april 4/2011 at $1000 and bought them back on may 4/2011 at $800 to close your position . can you please illustrate how my line on form d looks like.

    Thanks so much and waiting for your reply.

    Arun

    • Mark D Wolfinger 01/11/2012 at 11:44 AM #

      Arun,

      Show sale date as 4/20/11
      Show buy date as 5/20/11

      Show proceeds of sale = $1000
      Show cost = 800
      Show Profit 200

      Include commissions in both transactions

      • arun bhatia 01/28/2012 at 10:52 AM #

        Hello Mark:

        Thanks so Much for your clarification.