Tag Archives | covered calls

Covered Call Writing: Why You Will not be Assigned Early

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.

Thank you.

(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?

***

Jill,

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
$2,800).

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.

[Follow-up]

'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.

750

New_Trader_FAQ_promo

I am one of more than a dozen contributors to this book.

Read full story · Comments are closed

Risk Management: Making those First Critical Decisions

The topic of managing risk was introduced in a five part series. It's time to get into more of the details.

Risk Management: Choosing the first line of defense

When you own a position that can lose money and continue to become
riskier as market events unfold, the first two concerns (at least my
recommendation is that these be placed at the top of the list) are:

  • What specific action will you take before serious
    trouble arrives?
  • What has to happen to trigger that action?

Let's consider a simple (commissions ignored)
example. Writing covered calls:

You invest $5,400 to buy 200 shares of XYZ @
$27 per share

You write two
calls, expiring in 60 days.  The strike price is $25 and you collect a
premium of $350 for each option.

Your
cost basis (or break-even point) is $23.50 per share.  In other words, if the stock is above $23.50 when expiration arrives, the trade is profitable.

When owning a covered call position, you recognize that when this stock is above
the strike price after those 60 days pass, you
will be assigned an exercise notice and sell your shares at $25.  Net
profit in this example is $300.

If the stock moves higher and higher prior to expiration, nothing is lost and risk does not increase.  The higher the price, the greater the probability that you
will earn that profit.  Some traders find a rising stock price to be upsetting.  Don't let that happen to you.  You chose a strategy, are about to earn the maximum possible reward from that strategy, and a rising stock price makes it even more likely you will win.  You win.  Don't let anyone tell you this is a loss.

If a rising stock price is good for your position, then it's likely that a falling stock price is not.  There is risk of loss when the stock is below the strike price ($25) at expiration.  After 60 days, the calls expire worthless
and you own the 200 shares @ $23.50. That's better than the $27 you paid for the shares, and writing the covered call option has been beneficial.  However, the position had little downside protection, and if the stock falls far enough, this position may be losing money and threatening to lose even more.

There must be some point at which you take action to reduce future losses, and  increase the chances of making money going forward.


Time out

'Going forward' is a key phrase.  If you want to be a successful trader this is an important, albeit controversial, concept to grasp.  Most traders – both experienced and new – have a blind spot in a situation similar to this.

The usual method of evaluating a position is based on the original trade – and the price at which that trade was made.  I take a different view.  To me the original trade is history and no longer relevant.  I examine a position as it is priced right now – and then decide if I want to continue to own the trade at its current price.  What matters to me is the risk/reward going forward as well as the probability of success.  If the position is currently profitable plays no role in my decision.  I either want to own it or I don't.  If not, I exit (or perhaps make an adjustment instead).  Only after the trade is closed do I worry about whether it made or lost money. And that's for the purposes of record keeping.

If the position is currently under water (losing) the general plan for the majority is to base a strategy on the chance to earn enough to eliminate the loss.

This is a psychological trap that hurts your profitability. I hope to convince you to avoid this way of thinking.

When trading, your top goal is to make money with an acceptable level of risk. You do not care (or should not care) which position produces those profits.  You don't care which stock provides those profits.  Your job is to gather those profits.  You already understand the concept of making money.  Managing risk is another, and more important, job.

I know some believe that if you make money, nothing else matters.   And I suppose that idea sounds reasonable.  However, if you are taking much more risk than you realize; if you are getting good results because nothing bad has happened; then sooner or later statistics become reality.  Those '90% chance of winning' trades are expected to lose approximately one time in 10.  Yet, when it happens, the trader seems to be unprepared.   It's as if he/she believes it should never happen, and that 90% truly means 100%.  If unprepared, a single loss can wipe out years of gains.   

Thus, getting back to even is a meaningless goal (in my opinion).  Your goal is to make money today and into the future. If one position cannot do that for you, exit, take the loss, and find another that you believe will be profitable.  If you can 'fix' or adjust this position so that it fits within your definition of a good position, then that's a reasonable alternative.  But don't force the trade.  If you cannot fix it, dump it.  Too many traders only heed that 'dump it' advice when the trade is profitable and almost never, when it is losing money.

End of time out


Most investors/traders would continue using this basic strategy (covered calls) to write another option if the first call expires. 

When this stock is trading under $25 per share, and you own stock after the calls have expired, i recommend that you ignore your current cost basis (that's $23.50 in this example).  I recommend that you look at the stock as it is priced today – and decide what to do.  You can hold, you can sell, or you can write another covered call.

Conservative traders sell the 22.50 or perhaps 20 strike call.  They recognize the importance of selling an option with some protection against loss (if the stock continues to decline).  That downside protection reduces risk when owning the covered call position. 

If you understand the concept of accepting a reduced profit when the stock rallies beyond the call strike price, then you already grasp the basic concept of good risk management.  You are trading potential (and that's all it is – potential profit) for additional safety.

The more bullish investor may prefer to write a call with a strike of 25, and that's okay when the reason for the trade is to bet that the stock moves higher.

However, if the decision to write the 25 strike call is based on a mindset that demands making a trade that offers the opportunity to get back to even, then it's a poor decision.  You want to make money from today onward.  You cannot be concerned with money that has already been lost. 

The concept of 'making money going forward' is not often discussed, but there is plenty of talk about break-even prices.

The money has already been lost, and the best way to 'get back to even' is to find another profitable opportunity.

The 'get even' mindset is not one that's in tune with good risk management.

to be continued…

692



BG_OIC_banner

Read full story · Comments are closed

Exercising Call Options for the Dividend

Is there any circumstance where I would lose the dividend by writing covered calls?


GK

***

Yes there is that possibility. 

When you sold the call option, you granted to the buyer the right to purchase your shares by paying the strike price per share.  The option owner may elect to do that (by exercising the call option) at any time prior to expiration.  You have no say in the matter. You cannot force the call owner to
exercise, nor can you prevent it.

As soon as the option is exercised, the option owner is considered to have bought the shares.  As with a traditional stock purchase, the stock trade settles three days later.  As long as the option is exercised (and you are assigned an exercise notice), the stock has been sold. 

If this exercise occurs before the stock trades ex-dividend (without the dividend), then the trade settles in time for the person who exercised the option to be declared the stockholder of record when the stock trades ex-dividend, and hence, collects that dividend.  You, as the former shareholder do not get that dividend.

The larger the dividend, the greater the possibility of losing the dividend.

Also, the closer ex-dividend date is to expiration, the greater that possibility.  

One point must be mentioned.  No one will exercise an option that is not in the money.  And the option must be sufficiently in the money before it's owner will exercise.  Why? 

The call owner has a limited liability.  If the stock tumbles, the maximum loss is the value of the call option.  Once the exercise is complete, the former option owner now owns stock.  If the stock tumbles, the loss can be large – much larger than the loss experienced by the option owner.  Thus, the call must be far enough in the money that the person who exercises is willing to take the risk of owning stock instead of the call option.  The break point comes at the strike price of the option.  The exerciser must be willing to bet – and the payoff is the dividend – that the stock will not tumble below the strike price – where the loss can be substantial.

When exercising, the best time is one day before the stock trades ex-dividend.

You learn about being assigned an exercise notice the morning after the option owner exercises. Thus, if you see that you still own the shares on the morning the stock goes ex-dividend, then you collect the dividend. When  you no longer own the stock, and are no longer short the call option, on that ex-dividend day, then you do not collect the dividend.  How can you determine the likelihood of being assigned for that dividend?  If the call option is trading at parity – and that means it has zero time premium – and if the delta is 100, then it's right for the call owner to exercise.  Some call owners exercise more aggressively, but that is beyond your control.

643


Expiring Monthly:  All Options All the Time

Small_logo

Official launch date: Next Monday, March 22, 2010

Read all about it 

$99/year; 12 monthly issues


Subscribe prior to launch and you are entered into a random draw for gifts

Read full story · Comments are closed