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I've given up on professional money managers and taken to managing my own investments. I have some long positions but prefer scalping my favorite technology stocks! Disclaimer: Long $INTC, $MSFT Selling covered calls. Investment History: $NOK Was heavily invested in $NOK and sold in early sept... More
  • Basic HOW TO On Writing Covered Call Options 5 comments
    Dec 2, 2012 3:36 PM

    I was recently asking some questions on how to write a covered call option and what the downsides were. I got some excellent responses and wanted to share them here.

    sunnypt

    Luke, I started selling covered calls on about 1/3 of my positions in February. You sell a min of 1 contract which is 100 shares. It works something like this using INTC as the example.
    INTC closed at $19.56 yesterday. You buy a minimum 100 shares, (or use shares you already have) and sell calls against your position. This is called a "covered" call. Just like trading online, you see how much someone is willing to pay you for the call and decide which month and strike price to sell. Prices fluctuate quite a bit with the value being higher as you are further from the expiration date and higher as you are closer to the stock selling price. I like to keep it within a few months and at least 5% higher than the current stock price but read other opinions and do what you are comfortable with. You can today sell Jan 19 $21 calls for .24 per share. In other words, someone pays you .24 per share now and has the right, but not the obligation, to buy your shares of INTC for $21 per share between now and Jan 19. You still own the shares, you can't sell them and you still collect any dividend. Upside is you just collected an amount greater than the quarterly dividend (which is .225 by the way). Your sold options expires in less than 2 months time. As soon as the options expire, you do it all over again. You do that 6 times in a year and if you (maybe) get the same call income, you will have collected $1.44 in option income and your .90 of dividend income. Use today's price of $19.56 and that is 4.6% div yield and 7.4% options yield.
    Downside is INTC may go to $24 and you would then lose much of the potential increase since you got only $21 plus your .24 option income. This is still ok if you consider that you may have just paid $19.56 for the shares.
    There is more to it than this including your ability to "roll" that Jan call forward so that you don't actually lose the shares if the price goes above the exercise price and you pay commissions when you sell and when you are exercised.

    However, for me it has been like doubling my dividend on some great companies. I have 42 holdings today and only change 3-5 per year so I tend to be long on all my positions. This just enhances the income I get on my portfolio. Andy

    mapz

    A call has an expiration date D and a strike price K.
    It entitles the holder to buy the shares for K$ at any time before expiration D.
    The longer the call lasts, the more it costs.

    Calls are liquid traded instruments and can be bought and sold.
    If you own such you can sell them and this has no further consequences other than collecting the sell-price.

    If you do not own them, you can also sell them, then this is called
    "writing the call" and you are the call writer.
    It means that you have created a heretofore nonexisting quantity of such calls.

    Now the transaction has more serious consequences. You have given someone else the right to buy a number of shares of INTC from you for K$ a share.

    At any time before expiration you could be "called upon" to deliver the shares for K$ a share.
    This will only happen if INTC trades above K, since otherwise there is no point in "exercising" the calls against you.

    If you don't have the shares ("naked call writing"), then you need to go out into the market and buy them at the prevailing price (>K) while only collecting K (a risk).

    If you have the shares ("covered call writing") then you simply deliver them.

    All in all you realize K+N for each share (N$ for the call, K$ for the share). This you limit the upside to your INTC position to K+N until expiry of the call.

    If INTC does not move higher than K before expiry, you keep N without delivering anything. You would do this if you do not expect share price appreciation beyond K

    before expiry
    (get paid for waiting).

    Should the price appreciate before expiry and you be very nimble, you can always increase the position in INTC.
    But there will be some "slippage".

    Unit: really one call refers to one "underlying" share but typically they are transacted in lots of 100 calls (also sloppily called "one call").
    So: if "a" call is quoted 1.6 and you sell "one" really you are selling 100 calls for 100 shares and will collect 160$ and are now obliged to deliver 100 shares
    should the call be exercised against you.

    Unless you have a very large account, your broker won`t let you do naked call writing.

    All the calls you write will have to be covered by existing shares in your account and

    these shares will be tied up (no selling) until expiry of the call.

    You do not transact directly with your counterparty, the exchange stands between you and the counterparty. So if an investor exercises a call before expiry, the exchange will randomly
    "assign" a call writer to deliver the shares. That could be you.

    Regardless of how high the shares go it is not optimal to exercise a call before expiry (complicated finance theory, optimal exercise is on the last day where the call can be exercised). But there are irrational investors in the market.

    Downside:

    Say the situation of INTC darkens and the price falls.
    If you want to sell INTC shares that are bound to some calls you wrote you must first buy back these calls.

    The calls will now be cheaper but the price of the call falls more slowly than the price of the share and thus you realize a loss.

    Also note: bid-ask spreads on calls are often high.

    All in all a position long share + short call simply has a different risk reward profile compared to long shares only:
    Potential losses are reduced by the call price while potential rewards are cut off beyond K (assumes the strike price is higher than the share price).

    Which one is preferable depends on your utility of money function (how greedy you are) and probabilistic stock price process you think your shares will follow. When this is all made precise, it can be decided mathematically which one is better.

    But note: a position longshares + short call is simply slower to transact and with higher transactions costs than long shares only, so there are opportunity costs if that reduces how nimble you are (if only psychologically).

    There are even more possibilities, as you could also sell calls with strike prices lower than the current share price.
    It would not be rational to exercise them against you before expiration.

    Now if you think about that, there seem to be endless possibilities.

    I strongly advise against it:
    (1) The transaction cost are nonnegligible since the calls often have ridiculous bid ask spreads.
    (2) If you do not already know all this, then you expose yourself to risk you do not understand such as

    Volatility risk:

    Example: your shares have gone down 10% and now you got cold feet and want to sell but since the shares are used to cover calls you need to first buy back the calls (and get hit with the bid-ask spread) and you think:

    Since my shares have gone down, the calls will now be cheaper,
    which normally they would be (but not enough to make up for the loss in the shares) but low and behold, the calls are now more expensive since a quantity called volatility has increased.

    Thus you get hit with:
    (a) loss in share price
    (b) call bid ask spread
    (c) price of volatility.

    Of course everything also works in the opposite direction (except the transaction cost which always work against you), volatility could go down and the calls (which you are short) become cheaper.

    This game is not suitable to be played by the usual individual investor.

    Luke Tomasello

    Thank you Andy and Mapz, great explanation.

    so if I understand this, I may want to write covered calls for my MSFT and INTC holdings which are really sort of income plays. I would ever want to write a covered on my NOK for instance since the whole point of that investment is extreme growth.

    Additionally and for instance, if I would be happy to take $21 for my INTC shares I purchased at $19.57, then writing covered calls makes perfect sense.

    If I had INTC shares I purchases at $27 I would not want to write covered calls lest I be assigned at $21 :\

    So far so good?

    And finally; if I have multiple lots of INTC, some at $19 and some at $27, can I associate a particular lot with the calls? (basically guaranteeing the covered calls I write are attached to the $19 shares.)

    mapz

    It is not necessary to identify the exact lot of shares you bought at the different price points --- only how many.
    Say you bought 100 at 19.
    Then you could write one call at 21.
    If you bought 1000 at 19, you could write 10 calls.

    Psychologically its understandable that you would not want to sell calls with strike 21 when the stock is at 19 and you bought at 27,
    since you would then be locking in a loss.

    But really it does not matter at which price you bought, all that matters is where you think the price will be going in the future.

    sunnypt

    Luke, Mapz is giving very good and detailed info. My take on your questions is:
    MSFT and INTC vs NOK calls. I own the first 2 and write calls on them all the time. Writing calls is pretty simple when the stock price is stable or falling slightly or even falling alot. You don't have to deal with being assigned and you are making more than anyone else with these holdings who is long. If share price is going up and goes past your exercise price.... which happened to me on JNJ, GE and MO, you have a decision to make before expiration. I have handled all 3 differently.
    1. Personally I thought MO was overvalued, so I let it go. I had bought at $17 or $18, sold the $30 call when price was $28 and price went to $32. I happily let MO go and bought CSCO which I thought was undervalued... and then sold calls on CSCO!
    2. On JNJ, I let it go at expiration and just waited until the share price dropped and bought it back UNDER the strike price. So, someone paid me more than I paid to buy it a second time.
    3. On GE, as assignment loomed, I had sold $20 calls and the price was about say $20.50 but my original GE stock purchase price was $24. So, I bought back the calls to "close" the position and sold a later $21 call. I sell far enough out when I do this to make money again on the transaction. In other words, I received more per share on the sale than I did on the buy, (to close).
    As for NOK, the growth stock, I would expect that you believe it would trade with more potential for gains than INTC and MSFT or at least is going straight up vs up and down like the latter 2. Selling calls may create the situation where you may have to buy back the calls and resell new options down the road more often. Or, you sell your NOK calls at a higher strike price, say 10% higher and the MSFT/INTC calls at 5% higher to reflect your belief that NOK is going higher, faster than MSFT/INTC and that you prefer to keep all your shares.
    I hope this helps. This is the great strength of Seeking Alpha. Regarded Solutions helped educate me to sell calls on my positions which I began doing in February. Since then I have added $20,000 to my income in my retirement account. Next year I am going to do it on my cash account and add another $20,000. It's like found money! Andy

    Thank you sunnypt (Andy) and mapz for the detailed info on covered call writing!

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Comments (5)
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  • Do you have any views or experience with calendar spreads. Using leaps for your long position?
    27 Mar 2013, 06:55 PM Reply Like
  • Author’s reply » No I don't, sorry.
    I currently only write calls on my long positions, or buy puts on stocks I'm very bearish on. Nothing as interesting as calendar spreads.
    27 Mar 2013, 07:44 PM Reply Like
  • I've been looking into using calendar spreads similar to a covered call but using deep in the money leaps (long term options) as the long position to take advantage of the leverage of options then selling calls against them in the exact same fashion as you would if you were long the stock and selling calls.
    New to the forums here and stumbled across your thread and found it interesting. I did a search here and found some more info on calendar spreads. Thanks for the response.
    28 Mar 2013, 02:03 AM Reply Like
  • you would essentially have to be cleared for naked call writing in order to sell calls against artificially long stock like LEAPS. If you are then I would sell calls with the highest Theta/closest expiration.
    7 May 2013, 03:16 PM Reply Like
  • Covered call writing is considered by most experts to be one of the most conservative options strategies for investors and because of this, it is one of the only ones that are allowed by many companies to be traded inside of an IRA account.
    For writing Covered Calls, we need to take a look at the opposite side of buying options, which is selling stock options .
    17 Apr 2013, 05:10 AM Reply Like
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