WRITING COVERED CALLS

by Mike Lally

Options trading is not confined to short-term traders, speculators and gung-ho gamblers who have got bored with the nags or the gaming house. Used with a degree of common sense, sadly not always common currency these days, and coupled with the focus firmly risk, options can add flexibility to an investors game plan both to make money in the relatively short-term and to offset the overall risk contained in a portfolio of volatile stocks. Options trading is a medium for short-term trading. It involves taking a sizeable risk because success is restricted to obtaining immediate results.

This requires accurate analysis and it is a form of sentiment trading at its most demanding. If the underlying stock fails to move in the nominated direction, time decay will reduce the time premium portion of the options value. Time can work both for and against the options trader.

A safe method of entering the options market is to write covered calls. These are contracts you write over stock you actually own. It may seem a little bizarre and counter-intuitive to enter into an arrangement that seems to diametrically oppose the very basic wish of wanting the stock you own to actually rise in price.

If you have bought a stock for the longer term and believe the price will not rise to any degree in the short term then a covered call is a passport to profit, as you will be in a position to make money on a slow-moving or stalled stock. More importantly, if you own a stock that is in a gradual uptrend and the trend is mature, you can use your ownership of the stock to write a covered call during a period when the stock makes a correction to the long-term trend line prior to continuing its rise.

There may be a temptation for many creative traders to use a written call as a de-facto stop-loss. I believe this is muddled thinking and is a dangerous concept. A comparison between the two makes little sense; a stop-loss is the best, cheapest and is a more reliable method to counter downside risk. As in most walks of life, it’s better to stick to the old maxim: horses for courses.

When you write a covered call, you are selling the call to a buyer. Normally the writer of a call will want the share price to fall in value or drift sideways. Trading mistakes are ubiquitous and part and parcel of the learning curve is to accept the market does not always behave agreeably.

Insurance is a key cog in most people’s financial lives: life insurance, car insurance, house insurance, travel insurance, limited liability and so on. When you write a covered call against the stock you own you are following this normal pattern of insuring yourself against a projected loss. You are buying downside protection. As in all insurance policies, we need to ask the question: is the premium worth the risk?

When you write the call you will receive a premium from the buyer. This is definitely the nicest part of the transaction and if it was left as that, we’d all be happy. It’s well-known that the majority of calls expire worthless and given this pleasant fact, you should more often than not keep the premium with little further worry. The odds are definitely in your favour compared with buying a call, but it comes with the following rider: Your analysis must be soundly based and you must employ a well-formed strategy.

If the price does rise and the written call has a strike price in excess of the price you paid for the stock you will have made a capital gain on the share you own in addition to the premium you receive for the call. If the price per share rises in excess of the premium you received then you will be exposed because you run the risk of being exercised and being forced to sell your shares at the strike price. The potential loss of the shares is offset and softened to some degree by the premium you received plus any capital gain.

If the price does rise and you are exercised, you will have to sell the shares to the buyer at the strike price which will be below the current market value. So if you do not want to sell the shares you will need to take defensive action prior to this or forgo writing the call over those particular shares. If having written a call and your analysis is faulty, you can take defensive action by buying back the option.

The profits from writing options can be described as relatively minor and it may barely seem worth the risk writing calls for such small profits. You need to consider that if you can make consistently small returns from your trading efforts, the effects of compounding (the magic word) the returns overtime will result in genuine wealth creation – small and steady is the best way to create long-lasting affluence.

If you want to make the journey towards wealth creation through shares you must have a strategy for making money when the market is not rising, and this can be a considerable amount of time. When the sharemarket is travelling miserably option trading can put a nice little earner in your back pocket while others are whittling away watching their portfolios reduce in value.

Do not under-estimate the other major benefit of adopting a covered call strategy – using the call to protect a buy-and-hold biased portfolio against losses – a form of protection.

A REVIEW OF THE BASICS

When you sell (write) a call option, you are selling the right to buy the stock (referred to as exercising the option) at a given price (known as the strike price) at or before a specific date (the expiration date). The price of the option is known as the premium.

The expiration date for stock options is the final date of the contract and in Australia it is usually the last Thursday of every month. In the United States it is usually the Saturday after the third Friday of the month. The options traded in Australia are called “American-style” options” or more commonly as “exchange-traded” options. These options can be exercised on or before the expiration date unlike European-style options which are limited to being exercised on the specific expiration date.

Recall, when you write a covered call you are actually selling a call against a stock you already own. This means that in the case where the price does rise you are placed in a position where you must relinquish the shares to the buyer if the buyer does decide to exercise. It is also possible to write options against shares you do not own but this is more dangerous and far riskier – that will be the subject of a further article.

We need to briskly cover the terms in-the-money, at-the-money and out-of-the-money.
Basically they refer to the relationship of the strike price to the stock price.
For calls to be in-the-money, the strike price must be less than the current price of the stock.
For calls to be at-the-money, the strike price is roughly equivalent to the price of the stock.
For calls to be out-of-the-money, the strike price is higher than the current price of the stock.
If a stock was trading at $30, a $25 call would be in-the-money, a $30 call would be at-the-money, and a $35 call would be out-of-the-money.
A trader seeking high risk and high return will often buy out-of-the-money calls.
A trader seeking reasonable risk and moderate return will prefer at-the-money or in-the-money calls.

You could consider writing either an at-the-money or in-the-money call. The premium you would receive for either of these selections would be greater than that of an out-of-the-money call because the out-of-the-money call would provide greater downside protection.

LET’S WORK THROUGH AN EXAMPLE

Assume we hold 2,000 NAB shares which we bought at $28. Later, we decide to write two 3200 calls for 50 cents. We will receive $1,000 in option premiums (2 * 1,000 * 50c). If NAB does not rise above $32.00 the call option will expire worthless and we will retain the full $1,000. Because we have received this amount of money we have managed to buy some downside risk. In other words, the share price can fall by 50 cents without a loss being incurred given we now have this amount of cover. If you had issued the two calls at the same time you bought the stock you would be entering what is known as a “buy and write” strategy. This is an alternative strategy we will cover in another article.

If NAB makes a gradual but unspectacular rise in price we will experience two pleasant outcomes. We will have witnessed our shares increasing in value and we will retain the $1,000 assuming the price does not increase beyond the scope of the contract – it does not rise above $32.

As the share price rises, the written call is threatened and the premiums increase. What can we do if NAB does rise above $32? If we fail to act the option will almost certainly be exercised and we will lose our shares below market value. Depending upon the price reached by NAB we could be looking at a substantial loss. When $32 is reached the option starts to be in-the-money.

We can in part justify this approach as we would still have made a capital gain on our shares – the difference between the purchase price of $28 and the strike price of $32 plus the $1,000 we received. However, if the price escalates beyond $32 we will experience, in risk parlance, some regret. This serves to remind us that we must understand we can only write covered options against shares we are willing to sell. You cannot afford to be wistful about this; you must be prepared to lose your shares.

An alternative and a much more agreeable strategy is to accept you have got the analysis wrong and take some remedial action. The best action to take is to buy back the call.

Suppose the share price has increased to $33.50, the call would then have an intrinsic value of $1.50. If we bought it back at this price we would lose $1 per share ($1.50 – $0.50). We can comfort ourselves having taken this course of action with the realisation we no longer have to relinquish the shares. In total the buy-back would have cost $2,000 (2,000 * $1).

Now the good news – we would have made $5.50 per share on our initial investment of 2,000 at $28. If we wish, having closed out the call, we can decide to write another covered call at a higher strike price. To calculate the cost of this total operation, add both premiums received – the initial premium plus the higher strike premium and subtract the cost of closing out the position. You may still suffer a loss but with a bit of luck you will keep your shares and hopefully enjoy further capital gain. This process is called rolling up and an example is shown later in this article.

There are a variety of defensive tactics ranging from simple to complex. The important point is to accept you can lose your shares and have a strategy to defend your patch when the necessity arises.

THE OPTION PREMIUM

The option premium is made up of three components: the intrinsic, time, and a volatility component. Whether you are buying or selling an option, it is important to understand how each of these affects the option premium.

To a beginner the terminology of options can be a little intimidating but I guarantee if you persevere you will soon have a smile on you face.

Let’s look at the premium composition: the intrinsic, time and volatility components. The intrinsic value of an option is the difference between the market value of the stock and the strike price of the option. It is how far the strike price is in-the-money. For example, if a stock is trading at $35, a $30 call would have a $5 intrinsic value in the premium.

The time value relates to the amount of time left until the expiry date. Generally the more time left on an option the more opportunity there is for the stock to rise above the strike price with the result being that the buyer pays more for the option. Providing the price does not rise above the strike price the seller profits by the full premium amount paid by the buyer.

Volatility is the key to options trading and refers to how the share price fluctuates on a daily basis. Proper consideration of share volatility is the domain of technical analysis. If the stock is making large price moves it has the potential to rise above the strike price and this makes it more appealing to the buyer. However, volatility is a strange phenomenon and it is not unusual for the price of a stock to rise and the premium of the option to decline due to volatility. Understanding the nuances of volatility is not only the key to successful options trading, but failure to do so will lead to guaranteed losses.

WHAT BASIS SHOULD YOU USE TO SELECT A STOCK?

You should never buy a stock with the prime objective of trying to profit from an options strategy. Buy stocks for capital gain, nothing else. Options trading can be complementary to your equity dealings but it is not the main game – it is a sideline. The exception to this might be if you are a specialist options trader – a redoubtable breed. It is very tempting to many people to buy stocks solely because the options have high premiums but resist this temptation.

Prior to writing a call ensure the stock selected is highly liquid – never sit alone in the dark. Whenever possible, trade only when there is a reasonably high volume. The difference between the bid price and the ask price can be a large percentage of the premium on an option with low volume. This is known as slippage and it needs to be considered.

THE STRIKE PRICE

The strike price for stocks selling up to $1 is set at increments of 10 cents.
The strike price for stocks selling from $1 to $4.99 is set at increments of 25 cents.
The strike price for stocks selling from $5 to $9.99 is set at increments of 50 cents.
The strike price for stocks selling from $10 and above is set at increments of $1.

The strike price you choose virtually depends upon the analysis you undertake on the stock itself. If you are unsure of the immediate future direction you should not write an option. Do not buy or sell options if you are uncertain in your own mind of the probability of the stock price performance. Your analysis should give you the green light and the confidence to proceed.

If your analysis produces a positive outlook for the stock you should consider writing out-of-the-money calls. In this case the premium received would not be as great as an at-the-money or in-the-money call because for both of these the downside protection would be limited. However, you can earn more as the price increases.

WHICH MONTH SHOULD YOU SELECT?

One of the important components of options trading surrounds the issue of time. As the option approaches the expiry date the time decay accelerates. It is best to select the nearest month and make adjustments as necessary. The more time the option has until maturity, the greater the time value in the price of the option. An option will lose value quickly as the expiry date draws near. The time decay and loss of value does not linearly reduce – it is dangerously exponential. The time decay curve displays a gentle slope in the early days of an options life and then accelerates downward towards the expiry date.

If you are trading options as part of your overall portfolio make-up, you may want to make adjustments during the final month. Options writers should be looking at a time span of a few short weeks given this acceleration of time. This will ensure the buyer has less opportunity and the writer less time to worry. There’s nothing more certain than share price uncertainty. Prediction of future volatility is something we all would like to know; however the market does provide one clue – volatility always increases, at least mentally, the moment you write a call! You can be caught out in the blink of an eye. A buyer has the opposite perspective and prefers sufficient time to allow the option to move in the preferred direction.

THE RAWHIDE CONNECTION – ROLLIN’, ROLLIN’, ROLLIN’

The only strategy the embryonic options trader should adopt is to keep it absolutely uncomplicated. Many traders fail to profit from options because of the desire to over-elaborate. Another mistake made by the innocent is the belief that buying cheap options will lead to untold sums, but this rarely happens. Option trading is a magnet for traders, speculators, investors, hedgers and rampant gamblers. The flexibility is very appealing but does bring the unwary undone.

The fact that you can enter a position where you can make a tidy profit when the share price rises above a strike price and also make a profit when the share price stays below a strike price makes it an appealing contract. Throw in the opportunity to make money when share price rises above one price and below another and countless variations on a similar theme and it’s little wonder many people are seduced by this form of trading. The market, however, was not set up to make you rich – you have to earn your stripes and not lose your shirt in the process.

Adjustments can be made to your strategy if your initial analysis proves to be incorrect. I referred earlier to rolling up, the act of buying back the call that was sold and selling a new call with a higher strike price. There is also rolling down where a lower strike price is used, and rolling out where you use a longer expiration date.

When should you consider rolling? A guideline is to act when 75% of the premium has gone. Once the premium of the option has declined to this point, most of the downside protection has all but disappeared.

Prior to invoking such a strategy, your first step should be to clinically analyse whether you should retain the stock. If the analysis shows that the stock should be sold, take this action and sell. You can set up a new covered call position with another stock. Here are a few examples which exclude commissions and slippage.

Example 1: Rolling Up
You buy a stock with a share price of $36
A $37.50 call with 40 days to expiration is sold for $2.20
Thirty days later the stock has increased in price to $40
You decide to roll up:
You buy back the $37.50 call for $3.10
You sell a $40 call with 10 days to expiry for $1.50

Sell $37.50 40-day call +2.20
Buy $37.50 10-day call -$3.10
Sell $40 10-day call +$1.50
Stock increases by $4
Total profit $4.60

There is a $1.50 profit differential when rolling up rather than allowing the call to be exercised ($4.60 – $3.10). The cost of doing business would reduce any profit. If a stock does rise to a large extent it might be preferable to allow the option to be exercised. If a large increase does occur it is likely that volatility will be correspondingly high and the original option may be too expensive to buy back given the intrinsic value it will contain.

Example 2: Rolling Out
You buy a stock with a share price of $36
A $37.50 call with 40 days to expiration is sold for $2.20
Thirty days later the stock is still at $36
You decide to roll out:
You buy back the $37.50 call for $0.50
You sell a $40 call with 40 days to expiry for $1.50

Sell $37.50 40-day call +2.20
Buy $37.50 10-day call -$0.50
Sell $40 10-day call +$1.50
Total profit $3.20

With only 10 days left on the $37.50 call most of the premium has disappeared due to time decay. The strategy in this instance is to roll into next the months call which will provide additional downside protection.

Example 3: Rolling Down
You buy a stock with a share price of $36
A $37.50 call with 30 days to expiration is sold for $2.20
Twenty days later the stock has reduced to $35.80
You decide to roll down:
You buy back the $37.50 call for $0.50
You sell a $36.50 call with 10 days to expiry for $1.30

Sell $37.50 30-day call +2.20
Buy $37.50 10-day call -$0.50
Sell $36.50 10-day call +$1.30
Stock decreases -$0.20
Total profit $2.80

Always bear in mind the volatility influence. Large moves up or down in share price will cause significant volatility change.

WHEN YOUR PLAN FAILS

It is to a trader’s advantage that strong consideration to writing options is given rather than being confined to buying. The probability of success when buying options does not compare favourably with selling. I have mentioned a chief benefit of writing covered calls is the downside protection you receive by the premium amount. This can compensate for the capital gain you will forfeit if the share price falls. Additionally, you have made money when the stock has failed to rise.

A potential disappointment occurs if the price suddenly gaps up and the premium you received is comparatively small. This is a major setback as the small premium you receive will seem minor when compared with a major positive price upswing and you are exercised. Also recall that you need to philosophically accept occasionally having to relinquish your shares if the option result does not meet your expectations.

The sole purpose, I believe, of writing covered calls is to make small but attractive profit several times over the course of a trading year during corrections to a major trend. Apart from this appealing feature they can also be used as a hedging tactic – a form of insurance. When markets are uncertain, this is particularly useful. The lifeblood of any wealth creation plan revolves around the magic weaved by compounding several small but consistent profits.

It is vital to grasp the significance of intrinsic value, time decay and volatility. Whenever you do your projections, don’t forget the effects of the costs of doing business and the difference commissions and slippage can make to a relatively small profit margin. Finally, a word of warning.

BUYER’S REMORSE

A difficult situation for many traders and investors is the failure to recognise that there is a linear relationship between price and time. Self-denial is part of our nature and we all too frequently deny accepting a mistake has been made. Many will take extraordinary lengths to avoid doing so. Ultimately, the market forces many people to face reality and accept the truth though many are reluctantly dragged kicking and screaming to the obvious conclusion.

When the share price refuses overtime to move in the required direction, a combination of frustration and desperation will unwillingly force many to admit defeat and finally sell. Unfortunately, it’s usually far too late. After being paralysed watching a stock disappear into a financial black-hole, many investors will surrender. Another characteristic hazard occurs when many buy on the basis of good news and tips – they often buy when the price is high. They feel trapped and this leads to buyer’s remorse with the desire to get out at break-even if possible. Options trading requires a cool head, a clinical approach, a robust strategy, a “feel” for probabilities and the courage to act decisively.