Writing covered call split strikes

Mark – options question for you. Say you want a goal on average of 1-2% per month on part of your portfolio with a mostly passive investing style.

What if you have a stock @ $80 w/ 3 weeks to expire; the 77 call is 4.50, 83 call is 1.40. You buy stock and sell 1/2 shares on 77 call, other 1/2 on 83 call. If at expiration it’s >= 83, you make about 3.5%, at 80 about 1.7% which is in goal window, 77 and below you lose accordingly, so this would be a bullish position.

In the <= 77 case, if you immediately sold those same strike calls the next month, and if stock got back to 80, you're all right because you'd earn the time value as income, and for those 2 months more than likely still be in the 1-2%/mo range. What are your thoughts on something like this? For this scenario, are there any tactics you would employ before expiration, if the price went below 77 or above 83? Idea is to reduce pain or increase the return, Is there a point at which you get so deep in the money that you'd need to buy to cover, say if got to 88, cover the 77 and 83 and sell the 85 and 91? Don

Hello Don,

All covered calls are bullish.

A good answer requires a book chapter because you are talking about entering a position, managing risk, rolling the position and perhaps exiting. That’s a lot of ground to cover.

The key parts of my thoughts are as follows:

1) I would NEVER take this approach. That is not saying that you shouldn’t, but it’s not for me. And I do not recommend it.

2) When writing covered calls. I have two rules that are unbreakable. The first is that I want to own this stock, today, at the current price.

I am not buying it because the option premium is attractive. I assume this is a stock you want to own. If not, wait to write covered calls until you find such a stock.

3) When choosing the call to sell, I pick the one that I believe is ‘best’ today, under today’s market conditions etc. True, I may have a difficult choice between the 77 and 78 strikes and decide to some of each, or I may have a similar problem choosing between the 82 and 83 strike prices. However, I would never choose strikes so far apart.

I don’t like the idea. I believe it’s an attempt to get too fancy in an effort to earn more money. This is only a portion of your portfolio. You have a stated profit target. If you write only the 77 calls, you can reach that target. More than that, you can achieve it with a reasonable amount of downside protection. In other words – you have some insurance.

That’s ideal. You can meet your goals plus have insurance. Your tactics trade that protection for the chance to earn more money. That does not feel right. Are you being honest with yourself? Is the stated 1-2% per month really your goal? If it is, you should find the most conservative method for achieving it. You can seek higher returns with a different portion of your portfolio.

4) One thing I must warn about: You say ‘if it gets back to 80, you’re all right…’ Why do investors always take that positive tack? Instead, ask what if the stock moved to 65 instead of 80? That is a far more important question. Your financial future depends on your ability to find a satisfactory answer to that question.

5) Do you truly believe your initial premise: You want to earn 1-2% per month on part of the portfolio? If you do, the answer is staring you in the face. Write the 77 calls. The time premium is $150 and that represents a return of 1.99% in three weeks on an investment of $7,550 (per 100 shares). Isn’t that good enough? Isn’t that better than your goal? Why must you sell some of the higher strike calls? That suggests to me that you really have no game plan, no target, and just want to be bullish and collect as much as possible. Nothing wrong with that idea, but covered call writing is not the appropriate strategy for that very bullish mindset.

6) In fact, I would seek additional safety and write the 76 calls if they exist, and if the premium is sufficient to generate the desired return. Again, this is based on your overall plan.

7) If I had adopted your plan, and if the stock moved near 77 prior to expiration, my thoughts would be that I have been very careless with one half of the portfolio. Those 83 calls ceased to offer any downside protection well before I found myself in this situation, and I know that I would have taken defensive action sooner.

There are many such ‘somethings,’ and I do not have anything specific to recommend. Perhaps covering the 83 calls and selling a LOWER strike price call option that expires one or two months later. I’d suggest the 80 strike – because 3 points OTM seems to be the level that you want to trade. Me, I’d be selling the 74s or 75s. [If you think that’s a bad idea because it may ‘lock in a loss,’ let me assure you that failure to lock in losses – when appropriate – is the path to blowing up a trading account]

I agree that it is important to reduce the pain. The decision on when to take that action must vary and is dependent on the trading style of the specific investor. Some want protection and take limited profits. Some want profits and trade with much less protection. Neither is ‘better’ than the other.

8 ) If the stock were above 83, I’d hope it moved above 100 quickly. I never, and I mean NEVER, try to increase the return. And there is never a ‘need’ to cover. That move is 100% voluntary.

When I write a covered call, I am thrilled when I am assigned an exercise notice and achieve the maximum profit that my chosen strategy allows. I do not seek more. To answer your question, there is NO POINT at which it would be so deep ITM that I would want to roll.

Of course, your investing goals may differ from mine. However, I believe this type of trade (moving the calls higher to earn more money) is VERY HIGH RISK with VERY LOW RETURNS. I must ask: Why would you want to invest even more money into this position? If you are a trend follower or believe in letting profits run, then this strategy is wrong for you. If you are truly interested in earning a given profit – when you earn it (and much more in your scenario), can’t you be satisfied? Must you jeopardize those gains?

You are not Gordon Gekko and greed is not good.

With all that said, if you are a VERY experienced trader, if you have a PROVEN TRACK RECORD of knowing when a stock is moving higher, if you have a PROVEN TRACK RECORD of cutting losses and not allowing yourself to get hurt (and that includes not gambling away your profits), then maybe it would be okay to roll those calls higher. But I urge you to forget that idea. It’s simply too bullish and too aggressive.

Here’s a better suggestion for you. Are you aware that selling the 77 put naked is the equivalent to writing the 77 covered call? If you are, ask yourself how you would manage a position in which you sold 10 of the 77 puts and 10 of the 83 puts when the stock is 80.

Would you trade that differently than buying 2,000 shares and selling 10 of the (same expiration date) 77 calls and 10 of the 83 calls? If the answer is yes – that’s not good. These positions are the equivalent and they should be traded the same. If the stock rallied to 88, would you buy back the 83 put and sell the 91 puts? Not likely, is it? Then don’t do it with the covered call either. Perhaps you would not even sell the 83 put to begin because it is 3 points ITM.

I hope I have given you plenty to think about

942

12 Responses to Writing covered call split strikes

  1. Craig 04/06/2011 at 1:14 PM #

    Speaking of covered calls: I am studying selling covered calls and have a question I should know the answer to but decided to ask to be sure. I believe that If the underlying stock is even a quarter above strike price the stock will probably be called away.I was wondering if this means if the stock is above the strike price plus the premium the buyer paid it will be called away?

    • Mark D Wolfinger 04/06/2011 at 2:34 PM #

      Craig,

      Yes, you must know the answers to these questions, preferably before you ever write your first covered call.

      The following statements refer to the price of the underlying stock when expiration arrives. Not any earlier.

      1) If the stock price is above the strike price (of a call option) by as little as one penny, it is almost a 100% certainty that you will be assigned an exercise notice and (as you refer to it) having your stock called away.

      2) The premium paid by the option buy is irrelevant. Totally meaningless. If the option has value when expiration arrives, it will be exercised. If the option owner does not want to exercise, he can sell it to someone else who will exercise.

      What I cannot understand is why you would think that someone who paid $50 for an option would throw it away later, if it is worth only $20

      See this.

  2. WY Lim 04/07/2011 at 4:07 AM #

    1. When selling options, is it generally better to sell european rather than american options as american options has the uncertainty of possibly being assigned anytime that the option is in the money.

    2. Is an american option more expensive than a european option for the same underlying given the ability to exercise at any time of the american option?

    3. Are options on the exchange generally european or american?

    4. How do we differentiate between european and american options on underlying when we decide to trade them? How do we know if the option on an underlying is european or american?

    I apologise if these questions are elementary.

    • Mark D Wolfinger 04/07/2011 at 9:03 AM #

      WY,

      First, no question is too elementary. You are here to learn and asking questions is the right way to do that.

      1) No. There is no reason to worry about being assigned an exercise notice prior to expiration. It is often a benefit when the exerciser makes a mistake.

      There is one exception. If you trade a small account and the assignment would result in a margin call, then European options do prevent that margin call.

      American style options allow you to pick your individual stock, if you want to do so and European options are listed for trading on broad-based indexes.

      2) The American put is worth more because of the ability to exercise early. I know of no reason why the call would be worth more than it’s European cousin.

      3) American. All stock options, all ETF options are American style. The list of European style, cash-settled options is short. You caN find a list of such options here.

      4) If it is an index option and you cannot find it on the list, it is likely to be American. But the best way for a trader is to ask his/her broker via a phone call. oR, i suggest asking the Options Clearing Corporation: options@theocc.com

      Again, no apology needed.

      Regards

  3. marty 04/07/2011 at 12:43 PM #

    you said selling a covered call is bullish, i think it is bearish. by selling you are making a “bet” that the strike price is too high. buying a call would be a bullish bet.

    • Mark D Wolfinger 04/07/2011 at 2:55 PM #

      Marty,

      Full reply in tomorrow’s blog post.

  4. WY Lim 04/08/2011 at 12:05 AM #

    Thanks for your response, Dr Mark. It is very helpful.

    For 1) Can I assume that another exception is that an in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend as most of the time the amount of dividend would lower the option’s value by more than the option’s remaining time value. In this case, as a call seller I will almost certainly expect the call to be exercised.

    2) Understand that an american put is worth more than a european put as it frees up cash tied in the underlying for the put buyer. Thought american call should at least be worth as much as a european call. Shouldn’t an american call possibly be worth more as it can be exercised in the event when a dividend is involved.

    • Mark D Wolfinger 04/08/2011 at 7:18 AM #

      WY,

      1) No. If there is ANY (1.e. even one penny) of time value remaining in the option, it is just wrong to exercise. Wrong. Buy stock and sell option to collect MORE than the dividend.
      An option must be in the money by a sufficient amount before the owner should exercise. Once you exercise a call option and convert it to stock, then you own the dividend, but you sold the equivalent of a naked pout option (at the strike price of the call that you exercised).

      Thus the stock must be far away from the strike that the value of the put is LESS than the value of the dividend.

      Many traders get this wrong and foolishly exercise for a dividend that is far too small.

      Do not expect the call to be exercised unless the delta is 100.

      2) Yes. When there are dividends and when the call is deep enough ITM to be worth exercising for the dividend, then then Europeancall is worth less than the American – becasue it cann be exercised for the dividend.

      Keep in mind that most call options are NOT exercised for dividends. Why?
      a) Not deep enough ITM
      b) Dividend is too small (risk described above plus the cost to own stock through expiration often costs more than dividend)
      c) Many stocks pay small or zero dividend

  5. wylim 04/08/2011 at 9:16 AM #

    Thanks, Dr Mark. I get what you mean. It appears not to make much sense to exercise if there is time value in the call when selling the call and buying the stock is better.

    Earlier saw the info in point 1) about exercise under the heading ‘Difference in value’ in

    http://en.wikipedia.org/wiki/Option_style

    wylim

    • Mark D Wolfinger 04/08/2011 at 10:43 AM #

      LW,

      But some people do exercise their call options anyway. I cannot understand why they would do something so foolish.

      I see the Wikipedia quote, and it’s true. But the conditions necessary for making a PROFITABLE exercise are ignored.

  6. WY 04/10/2011 at 12:02 PM #

    Thanks, Dr Mark. I suppose they may not realize that exercising their option is not the best way to go about doing things.

    • Mark D Wolfinger 04/10/2011 at 5:28 PM #

      WY
      Some people cannot be convinced. Not our problem.

      Regards