Covered call writing can be simple or complex, depending on your approach. Through the selection of the underlying stock to buy and the particular call option to write, the strategy can be tailored to a multitude of different risk levels and market conditions, as well as a variety of goals and approaches. This chapter discusses the various uses covered writing can be put to and the ways it can be modified to suit various circumstances.
In the process of creating a covered write, you will discover that it alters not just the risk/reward parameters of your stock investment but the way you invest as well—your selection process, your expectations, and your follow-up activities. The change in your thinking and the implementation of follow-up activities are what will turn a position in your account into an ongoing investment strategy.
You may feel that it is not necessary to monitor a covered write as closely as a stock position by itself, and that is generally true. However, you should remember that the option has a limited life and that you will need to take follow-up action at some point. Follow-up actions can be taken at any time, even before the option expires, and may be warranted if the stock moves sharply or if you have reason to believe it may do so. Such follow-up actions are discussed later, but first consider the simple case—the one where you do nothing until expiration.
Once you put on a covered write, you need not take any further action, even at expiration. You can do absolutely nothing—you don't even need to be around. You can be in Tahiti on expiration day if you want. There is nothing about a covered write that adds any more risk than if you simply owned the stock.
At expiration, the option will do one of two things: expire worthless or be exercised. If the option is exercised, your stock will be called away, and you will have an automatic sale of the underlying shares just as if you had put in a sell order. On the other hand, if the call expires worthless, it disappears from your account by the following Monday and you revert to your status as a simple stockholder. Exercise is now automatic for all options that are at least one cent in the money (ITM) at expiration. If the stock closes anywhere below the strike price of the option, you can count on not being assigned. (Note, however, that while extremely rare, there could be extenuating circumstances under which a holder might decide to exercise a call that has no value on the close before expiration. Such a circumstance could include a surprise announcement immediately after the close on Friday that would make the stock likely to trade higher in after-hours trading or on Monday.)
While being assigned provides the maximum gain for the period, having calls expire worthless is also gratifying, because you know you have done better for the period than someone who simply owned the stock. What's more, you are now free to write another option and take in still more premium.
Once you begin writing covered calls on a regular basis, you will discover numerous reasons why you might want to close or modify a position before expiration. News affecting the stock may become public, or you may need the money for something. Or you may simply wake up one morning and ask yourself, “What was I thinking?” The reason is irrelevant. The ability to adjust your position on the fly is one of the great benefits of covered writing. One alternative is to close out part or all of your position. You can do this whenever you want, provided you have not already received an assignment notice on any of your calls. Of course, in closing, you will incur transaction costs and may realize a loss on one or both sides of the transaction, so you do not want to be day-trading covered call writes. But when the necessity arises, the ability to close is there.
Say that in September you buy ABC stock at $32 and sell a January 35 call for three points, for a net investment of $29 a share (not including transaction costs). Then in October, the stock falls to $27. You believe it could drop further and would like to prevent additional risk, but your call option still has nearly three months until expiration and is trading at 1.5. Closing would leave you with net proceeds of $25.50 a share ($27 for selling the stock, minus $1.50 for buying back the offsetting call). That gives you a loss of $3.50 per share (the initial net investment of $29 minus $25.50), plus transaction costs, on the covered write (compared with a $5 per share loss had you simply owned the stock and not written a call). If you believe that the stock could go to $20 or below over the next three months, then holding on to a short call that will only give you $1.50 more profit during that time may not make sense. Closing the whole position in that scenario is a justifiable action.
The important point to remember is that your net investment incorporates both the stock and the call option, but the stock contributes essentially all the downside risk. Therefore, it behooves you to assess where you believe the stock may go even more than where the option may go and not to be shy about closing the option or both sides if necessary.
Another tactic many people fail to appreciate is closing only part of the position. If you have 800 shares of a stock and write eight calls, you can always compromise by closing only four of the options. For some reason, people get stuck on the idea that it's all or none and don't consider lightening their position as opposed to closing it entirely. The same holds true for putting on the position in the first place. Not sure if you should sell a covered call on all 800 shares? Why not sell only four, or sell four at a conservative strike price and four at a higher one?
One caution on closing covered writes: You'd be very ill-advised to close the stock and keep the short call position open, even if you are trying to avoid taking a loss on the option. Whether or not you are approved for naked options, it is an unwise practice to close a covered write by selling the stock first and holding an uncovered short position in the call. You can, however, buy another call to create a spread with the one that is short, thus freeing you to sell the underlying stock without creating a naked short call. The call you purchase could be at a higher strike call in the same month to create a credit spread or a longer dated call at the same or lower strike to create a calendar spread. The purchase of a long dated call instead of stock in the first place is an advanced call writing strategy, which is discussed in Chapter 5.
While closing the entire covered write is sometimes justified, more often, you will decide to hold the stock and close only the option or roll your call position. Rolling refers to the process of closing out the short call position and opening a new one in its place. Think of it as simply substituting different calls for the ones you are currently short. This allows you to adjust the risk/reward potential of your position while leaving the stock holding intact.
The act of rolling involves both a purchase (to close your original short position) and a sale (to establish a new short position). You will generally want to execute the two transactions as closely together as possible to minimize the risk of having the stock move between the time you execute one side and the time you execute the other. Even though the stock could move in a direction favorable to the second half of your transaction after you've completed the first half (giving you a better price), why take that risk? Your objective is to have a covered write, not to day-trade options. Therefore, rolling is normally accomplished either in two nearly simultaneous transactions or as a single transaction executed as a “spread” order.
Having said that, there may be occasions when you wish to close your short call position and not reopen a new one at the same time. You could, for example, write a call option against stock and subsequently learn that some positive things may be brewing. Rather than cap your upside with a covered call, you may decide to close the short call position and wait a week or two to see if your stock rises or any news comes out. Trading in and out on the short call of a covered write is not recommended as an ongoing practice, but changing your mind for valid reasons now and then is completely up to you.
Rolling is a valuable technique, allowing you to manage the risk and reward of your covered writes after you have initiated them. However, it has a price. It will add transaction costs and can sometimes require additional funds to implement (if the call you repurchase is more expensive than the one you roll to). Furthermore, it will not always end up being a better course of action than having done nothing. As with changing course on any investment decision, your success is ultimately a product of the accuracy of your judgments.
Below is a discussion of how and when it might be appropriate to roll options up, down, or out. The following example will be used throughout:
Buy 100 DEF at $28.
Sell 1 Feb 30 call at 2.
Days to expiration = 60.
Suppose you buy DEF at $28 and write the DEF February 30 call at 2 in December. Suppose further that it is now January, and DEF is trading at $32 and looking strong. The covered write is working well, and you have an unrealized gain at this point: Your call is worth three points, netting you a potential $29 per share before transaction costs should you close both positions now. If the stock remains above $30 at February's expiration, you will achieve your maximum gain from the initial covered write. You can certainly opt to do nothing and wait for that to happen.
Original Scenario (two months to expiration) |
New Scenario (one month to expiration) |
DEF = $28 | DEF = $32 |
DEF Feb 35 Call = 0.5 | DEF Feb 35 Call = 1 |
DEF Feb 30 Call = 2 | DEF Feb 30 Call = 3 |
DEF Feb 25 Call = 4.25 | DEF Feb 25 Call = 7.3 |
But you may feel that the stock could move even higher over the next month. If you are that confident, you can adjust your position to allow you more upside potential by rolling up to the February 35 calls. The following pricing scenario exists (Table 4.1).
Rolling up to the Feb 35 call would involve buying the Feb 30 call to close your current position and selling the Feb 35 call to establish a new covered write. Since you are paying three points and receiving one, you are paying out two points net, or $200 per contract. This payment is your net debit for the transaction and represents an addition to the initial cost of the investment. This cost happens to cancel out the two points earned on the original option write, so in a sense, it is giving back the original premium received. But your stock has gone up accordingly, so you are still ahead of the game. Depending on how much time remains before expiration and how high the stock has moved, your net cost to roll up could be more or less than what you originally received. Even if you realize a loss in the option you are buying back, you should always have a greater gain (albeit unrealized) in the underlying stock than your loss in the option.
Why do this? The logic would be that you are increasing your upside potential, although you are also adding to your original investment and thereby increasing your risk at the same time. Your original position gained a maximum of four points at expiration if exercised (30 for your stock plus two from the option minus your net initial investment on the stock of 28). Your new position now gains a maximum of seven points if exercised (35 for the stock plus zero from options minus your investment of 28). Your breakeven point is higher now, and your time period is unchanged.
The comparison of risk/reward looks like what is shown in Table 4.2.
One way to decide whether this is worth doing is to look at your incremental investment and incremental gain. Here, you are putting in an extra $200 for an increase in your maximum potential gain of $300. That would be more than 100 percent on your incremental investment if realized, although when you figure in your transaction costs, it will be somewhat less. But what is the probability that the stock will actually be over $35 by February's expiration? That's for you to decide.
A little rough arithmetic tells you that the original covered write makes four points if the stock is above $30, while the new scenario makes four points if the stock is above $32 at expiration. Therefore, if the share price is below $32, you will have been better off not rolling, and if it is higher than $32, your roll will have been beneficial. (If you do this kind of quick math, you might want to toss in an extra half point for the transaction costs.)
This example used strike prices with five-point increments, but there are lots of situations now that offer 2.5-point increments or even one-point increments between strikes. Such situations offer that many more possibilities for rolling and are advantageous to the call writer.
Many people like the idea of rolling up for more potential gain on a covered write position but not the part about putting in additional capital. That's where rolling up and out comes in. You roll up in stroke price but also move out to a more distant expiration month. By moving out in time, it is frequently possible to get more premium from your new write than it will cost to buy back your existing one. In other words, you will be rolling for a net credit rather than for a net debit.
Suppose you wish to roll up to the 35 strike price on your DEF calls, but you want more premium than is available in the Feb 35 call. Try March. Say the March 35 call is 2.25. That's a reasonable roll, but it will still cost you 0.75 points, or $75, per contract to do it. Assume there is an April 35 call at 3.5. This roll would give you a credit of 0.50, or $50, per contract. The April 35 call would extend your covered write two more months, but in the process you gave yourself more upside on the stock and it didn't cost you a nickel (Table 4.3).
Many covered writers will not roll an option position unless they can do so for a credit. That is not a bad practice, since taking in additional premium will always have the net effect of lowering your risk. However, if you need to write a new call more than five to seven months away in order to generate a credit, you may want to think twice about whether that makes sense. A sensible rule of thumb to follow is that if you would not ordinarily consider selling a particular call against your stock position, then you shouldn't roll out to that call, either.
As you might expect, rolling down is a more defensive follow-up action. Suppose that instead of rising, DEF drops to $25 in January. If you are afraid that it might fall further in the next month, you can close the whole position and absorb your loss, or you can roll your option down to the Feb 25 calls. When you drop to a lower strike price, you should always be able to receive a credit, since the lower strike price will inevitably have more premium than the one you are covering. (If for some strange reason, it does not, then you would gain nothing from the move.)
The rationale for rolling down would be that the stock has declined and you are willing to give up some additional upside potential in order to protect your position more on the downside. Assume in our example that the stock drops and the Feb 30 call can be repurchased for 0.35. If the Feb 25 call can then be sold for 2, you can take in another 1.65 credit, or $165 per contract, by rolling down. The comparison looks like Table 4.4.
You will now have removed almost all of your upside but will have lowered your breakeven point. As with the scenario above, you could also roll down and out by going to the March 25 or even April 25 call for even more premium. Rolling down and out, however, is still defensive, and since it limits the potential gain from the stock during the option's life, it may prevent you from capitalizing on a recovery in the stock price. In fact, one danger in rolling down is that you may lock in a loss on the stock if, as in the example, the new strike price is below the price at which you originally bought the shares and you are assigned. If you are that bearish on the prospects for a particular stock, you might be better off closing the original covered write altogether or just rolling down within the current month to see what happens in the short term.
Rolling down can also be used as a safety procedure when executing very short term call writing trades on stocks with high implied volatility (for more aggressive investors). There are frequent opportunities for buying stocks and writing ATM or ITM calls within days of expiration for a potential 1 to 2 percent return. These opportunities have even become more prevalent now that weekly expirations have been introduced. One such example that occurs as we are writing is Morgan Stanley (MS). The stock recently closed at $28.98 and has a 29-strike call with five days to expiration selling at $.58. That would represent a 2 percent return for the week if the stock remains at its current price or moves higher. When you put on this ultra short-term covered write, you already have 2 percent downside protection to start. If the stock moves higher during the week, you need do nothing. If it trades down say half a point, you can hold, but you would not be protected for any further decline. If you suspect further decline during the week or simply don't want to take the chance, you could buy back the 29 call and roll down to the 27.5 call. Your original net cost for the covered write was 28.40 (28.98 for the stock less .58 for the call), so as long as you can get at least .90 credit when you roll down to the 27.5 call, you will break even—as long as MS does not fall below 27.5 at expiration. A quick look at theoretical values with the same implied volatility says that if MS traded down to 28.5 with three days to go, you would be able to roll down for .90 credit. In this manner, you looked to make 2 percent on your money for the week on any upward move, and you were able to protect your initial investment for up to a 5 percent loss on the stock. The ability to roll down is what puts the odds of this trade in your favor.
Rolling out (i.e., keeping the same strike price and neither rolling up nor down) has less to do with movement in the stock than with time. The most common situation in which you would do this is when you are approaching expiration and the stock is close to the strike price, whether just below or just above. Assume it is now the Friday morning before February expiration and DEF is trading at $29.95. The February 30 call might sell for 0.15 at this point. If the stock closes under $30, the option will expire worthless, and you could look to write the March or April 30 call on Monday. But the stock could just as easily close at say $30.25, in which case you would be assigned and your stock called away. Now, you may be ready to jettison DEF from your portfolio, in which case you are hoping it does get called away. In that case, no action is necessary. If, on the other hand, you like DEF and plan to write another call on it anyway, you may want to roll the option out to March and not worry about whether it closes above or below $30, or whether it opens higher or lower on Monday. Assuming you were planning to write the March call anyway, the additional cost of this move is the $15 per contract you must pay to close the February 30 call, plus the transaction cost. When rolling out at the same strike price, you will always take in more money than you spend, because the more distant option will inevitably have more time value. So you will be receiving money (rolling for a credit), but you should still view the cost of the purchase as an added expense, since it will reduce what you receive from the new call you write. It may not seem like much to buy back a call for $15, but if you did that enough times during the year, it could add up.
Your approach would be similar if the stock was trading slightly above the strike, at say $30.25, even several days before expiration. If you plan to hold the stock and write the March 30 call at expiration anyway, then you could roll out to the next month at this point instead of waiting for expiration. This is also commonly done when you expect to be travelling or busy and do not want to be worrying about expiration.
Summary on rolling:
Thus far, the discussion on rolling assumes that you are in a fully covered write and that you roll to a similar position by selling the same number of new calls as you were previously short. This will be the most frequent case, but you can roll for fewer or more contracts if you desire (although if you write more than you have shares to support, the extras are not considered to be covered). Say you have 1,000 shares of a stock and have written 10 covered calls and decide to roll them. Whether you are rolling up, down, or out, you may decide to write only seven calls, particularly if you can still get a credit for doing so. Similarly, if you were not fully covered to begin with—you had written only five calls, say, on your 1,000 shares—you could roll those five into, say, seven or even 10 new ones to cover your cost. The latter strategy is called partial writing and is discussed further in Chapter 5.
When judiciously implemented, rolling adds a tremendous amount of flexibility to covered writing, but too much of a good thing can be dangerous. If you are continually rolling positions, it may be appropriate to reconsider your original parameters for initiating covered writes. Some people, for example, will put on a covered write with a stock at $29.50 and sell the 30 strike call; then, as soon as the stock goes over $30, they look to roll. This will threaten the advantages of the strategy by adding unnecessary transaction costs over time.
In the book Far From Random, we discussed the results of behavioral finance studies that describe how a complex array of human emotions, predispositions, and biases enter into our financial decisions. When investing in stock, among the more prominent emotional issues you will encounter are: loss aversion (taking action against your best interests to avoid realizing a loss on a given stock); disposition effect (reluctance to sell a stock once you've bonded to it); and mental accounting (assigning a different value to money in one place over money in another). When you add covered calls to the investment mix, you change the behavioral perspective of simply owning stock and these emotional factors can change. Some of these changes are positive, and are the reasons why you write covered calls in the first place. Having less anxiety, for example, with day-to-day volatility is the biggest positive.
But there are also some issues that can become negatives. For one, it can be easy when your stock is sitting at say $70 per share for days to accept $3 for a two-month call option at 70. The annualized return on that call premium is more than 25 percent. But if the stock then runs to $75 at expiration, you may end up with a case of seller's remorse. Even worse, you are now faced with an emotional dilemma. Despite the fact that you are ahead of where you were when you initiated the call write (your net position then was worth 70 and it is now worth 73), you are going to have to repurchase the option at a loss (since it would now be worth 5) if you do not want to lose the stock to assignment. This typically results in a case of loss aversion—one of the most powerful emotions in behavioral finance—and one that is made even more acute by the fact that you have to make a decision by expiration or you will lose the stock. (Some people will opt to lose the stock simply to avoid booking the loss on the call option, even if they feel the stock has further upside potential or if they incur a tax liability by doing so.) At least with stock by itself, you can avoid taking a loss by simply deciding to do nothing and hanging on to the stock.
Another emotional issue arises from the misperception that the call provides downside protection in the same amount throughout the life of the option. If your call write is reasonably long-dated and the stock declines sharply in the near term, you may not receive as much protection as you think. For example, a long-dated call might have $5 of premium, causing you to perceive that you have 10 percent downside protection on your $50 stock. While you do have 10 percent protection, it is over the life of the option, not immediately. Should your stock drop to $45 right away, your option might only drop by a couple of points, since it will still retain time value for its remaining life.
Also, writers frequently experience an unreasonable fear of being assigned. Some investors write OTM calls against their stocks and then start getting nervous as soon as the stock moves up and the call becomes ITM. Such fear is not justified by the reality of early assignments, which are actually quite rare and which can be prevented quite easily by rolling the position. Nonetheless, people who write calls to reduce their anxiety and then end up simply trading anxiety over volatility for anxiety over assignment are probably not going to have a positive experience with covered call writing.
Your approach to covered writing can be short term or long term, conservative or aggressive, active or passive, and as unique to you as your signature. Between the myriad different stocks you can write calls on and the different ways you can structure your positions by varying option strikes and expirations, you have the flexibility to develop a highly original implementation of the covered writing strategy in your own portfolio. What's more, you can modify this implementation over time as market conditions or personal considerations dictate.
Before converting their investment strategy entirely to covered call writing, most people commonly adopt call writing on an experimental basis, attempting to enhance the returns or protect gains on existing stock positions. This is also sometimes referred to as overwriting. It is the simplest form of covered call writing, since the stocks are already in place and you only need to find an appropriate call to write. Underlying this approach is the philosophy that stock picking and covered call writing are independent activities—you buy stocks for their long-term potential, and you selectively write calls on them when the situation merits—usually when you feel upside is limited and are in a more defensive posture concerning the stock or the overall market. The strategy typically involves writing OOM calls when looking to enhance returns and ITM or ATM calls when in a more defensive mode.
Examples of circumstances that lend themselves well to incremental call writing include:
These can all be reasonable approaches, but they contain traps for both individuals and professionals who use them. Although relatively easy to implement, the incremental income approach to covered writing can disillusion some who try it. The crux of the matter is the expectation that additional income generated by selling calls on existing stocks is “free” money—like getting a quarterly dividend on the stock. The trade-off in lost upside potential too often gets lost in the logic. At some point, one or more of the stocks will exceed the option strike price at or before expiration. The stockholder will then have to buy back the call before it expires (perhaps at a loss), or have the stock called away, or need to roll the position. The assignment could create an unexpected tax liability on the stock if there is a capital gain. None of this is truly bad news unless one expects that it will never happen. The lure of this so-called “free money” approach was behind the creation of several mutual funds in the 1980s. The idea was that the fund managers would create a portfolio of quality stocks with reasonably high dividends, such as utilities, and then write call options against them to further enhance the income. These “option income” funds were positioned as hybrids between fixed-yield and regular stock funds, and they were targeted at conservative investors looking for an attractive yield plus the opportunity for some additional growth.
Most of these funds eventually closed—not because they lost money, but because they failed to deliver the promised attractive yield with upside growth potential. The yield was there, but the growth lagged that of the general market during the period. The funds also had problems with executions. Managers tried to write far out-of-the-money options on the premise that these would leave plenty of upside and that, however small the premiums earned, they would still enhance returns. But high-dividend stocks (frequently utilities) tend to be less volatile. They therefore have lower option premiums and tend not to have strike prices much higher than where the stock currently trades. So the funds gave up significant upside appreciation for a meager amount of additional yield. This is not to say that writing incremental calls on an existing portfolio is ineffective. It's just important to manage one's expectations about the benefits and consequences of such a strategy.
Other traps to watch out for are discussed below. The biggest potential problems stem from the fact that those writing calls for incremental return tend to do so based not on scientific factors but on subjective “feelings” that although a stock has an attractive long-term upside, its near-term prospects are not great. This can lead to mistakes such as the following:
There is a similar tendency not to write calls on a stock that is moving steadily up. Yet this is when both volatility and the price of the underlying stock may provide you with the best opportunities to capture option premium and also realize gains on the stock. The bottom line is that you can never know for sure whether writing a call will be more beneficial than simply holding the stock during the same period until expiration. So if you're waiting to decide whether to write, you are basing your decision on past performance rather than what may happen before the next expiration.
The alternative to writing for incremental return is to specifically select stocks that are attractive as covered writes, seeking total return from stock appreciation plus a continuous flow of option premium. When you have decided to grow your overall portfolio over time in this manner, then you will have embraced the total return, or buy-write, approach to covered writing. This is simply the generalized approach that seeks growth through the total opportunities presented by both a stock and its call options together, and that recognizes covered call writing as your primary ongoing investment strategy. In doing so, you concentrate your research on stocks that have listed options and determine which are attractive not just on their own merits, but in combination with their call options. This could mean rejecting a stock that you like fundamentally but for which there are no options, or choosing to establish a covered write on a stock that you might not have invested in by itself. By using at-the-money and out-of-the-money calls in different months, you can adjust the strategy to achieve a balance between option premium and potential stock gain with which you are comfortable.
There is a substantial difference in orientation between the incremental and the total-return approaches. Stock selection is different, timing is different, and ongoing portfolio management is different. If you are astute, you might be able to mix the two strategies, but when you do, you subject yourself to the traps inherent in both. In the total return approach, you select both stocks and calls based on their attractiveness as part of a covered write. This is a departure from selecting stocks based solely on their long-term fundamentals and business prospects. As a covered writer, you also want positive fundamentals, but you can loosen the requirements quite a bit in terms of price and time objectives, since the stock simply has to have a strong likelihood of being above the strike price of the call by expiration. Furthermore, the call premium has to be attractive relative to the stock price and to the call's theoretical value.
Total-return investors don't have to guess when it might be appropriate to write a call. Their approach is predicated on the strategy's ability, over time, to produce consistent returns without guesswork. They can use fundamental research to help pick stocks, but not in the same way—or with the same objective—as the incremental writer. Thus, the objective in total return is not to buy a stock for $40 that has the potential to trade between $60 and $70 in one or two years. The objective is to buy a stock at $40 and write a 40 or 45 call based on the judgment that the stock is likely at least to remain where it is, if not go higher, in the next month or so. There is therefore a stronger need for the investor to feel confident that the stock won't drop to $30 in the next month, than that it will attain the far more ambitious (and often more elusive) goal of rising to $60 in the next year. A solid fundamental picture helps lower the possibility of a sharp decline. But covered writers should also study technical trends and support and resistance points to determine likely scenarios for the duration of their option positions.
Buy-writers can identify potential investment opportunities in two ways: (1) by identifying stocks they really like and seeing whether they have options traded on them; or (2) by screening all the attractive covered writes to find those involving stocks they like. Since options are available on only a relatively small percentage of stocks, this latter method is the more efficient and can be accomplished using software programs or Internet-based services. As a buy-write practitioner, once you have become familiar with a number of optionable stocks, chances are you will return to that group again and again for new ideas when funds are available. If, for example, you like the fundamentals on Apple Computer and establish a covered write only to have your shares called away after a month or two, you are likely to find subsequent opportunities in Apple during the following months. In fact, it is common to reestablish a position in some of the same stocks repeatedly when the share price and the option premium appear attractive.
Investors who take the total-return approach to covered writing range from quite conservative to highly aggressive. The conservative investor would select less volatile stocks and write calls that are closer to being at the money and a little farther out in time. The aggressive investor would look for stocks more likely to make big moves and would write out-of-the-money options in nearby months. Of course, there is nothing to say that you can't do some of both or vary your posture over time.
Like the incremental-income approach, the total-return approach also has its traps. Key among them are the following:
The main point here is that many of the benefits that accrue from covered writing stem from the discipline that the strategy imposes. You can mix strategies or even modify your strategy over time, but if you are not clear about your implementation, chances are you will have difficulty maintaining discipline and will fall into one or more of the traps mentioned above. Whether you are writing for incremental return or total return, your overall success in, and satisfaction with, covered writing are greatest when you are clear about your implementation and mindful of the traps.
Depending on the stock, it's possible that you could have anywhere from 10 to more than 100 call options to choose from at any one time. However, the pool decreases quickly when you limit the candidates to those that match your game plan. If you like to write at-the-money calls with one or two months to expiration, you will zero in on these. If you are writing for incremental return on a stock you already own, you will probably start with the highest strike price available and work down from this or move out in time until you find a call with sufficient premium.
The strike price decision essentially grows out of your risk posture and will generally boil down to a choice between one or two strikes. The vast majority of covered calls that are written are for the strike closest to the current share price, whether in- or out-of-the-money. Table 4.5 illustrates how different prices can correspond to different strategies, using a September-expiration covered call written on Dell, Inc. (DELL), when the stock was trading at $26.25.
Bear in mind that while the situation illustrated in the table is typical of the trade-offs between in-the-money and out-of-the-money calls, the scenario is dynamic. A $1 move up or down in share price could easily change which call you write or even cause you to reject writing on that stock at all. Many times you will like a stock but not find a call that suits you. The following month, or the following week, the same stock may offer a much more attractive write. Much of this variation in attractiveness has to do with where the stock is trading relative to the strike prices of its options. It is most likely to happen with stocks priced between $30 and $50, whose options have strike prices in $5 increments. Say you prefer covered writes where the underlying stock is trading one or two dollars below the strike price. If a stock you like is trading at $38, for example, you most likely would be comfortable with the amount of premium that the 40 strike offers, and you would still have some upside potential in the stock. The 35 call would probably be too far in the money to offer a high enough return and would offer no upside in the stock at all, while the 45 strike might not provide enough premium. But if the stock is trading at $35.50, none of the available strikes may suit you, and you may decide to write on a different stock for the present. Next month, the first stock may be exactly where you want it. How you choose between in-the-money and out-of-the-money calls is up to you. There are good rationales for both at different times, and even for using both at the same time on different stocks. It all comes down to how much of a stock's upside potential for the period you are willing to trade away for more return. Be advised, however, that if you find yourself always selling the in-the-money calls, you may not be allowing yourself enough upside potential in the long run to offset the risks on the downside. While downside protection is often advantageous, if you believe that stocks do in fact have a long-term upward bias, you should profit from that growth if possible.
Time premium is the component of an option's total premium that diminishes over time, and as a call writer, this decay is what makes you money. Chapter 2 explained that time premium decays faster as an option approaches its expiration. That means that all other things being equal, to take the most advantage of the dissipation in time value of call options, writers are best served by writing the near-month option whenever possible. That is why so much of this book uses examples that are one to two months in duration. You can frequently find very attractive covered writes even in the last one to three weeks before an expiration. Say you are assigned on a position and have money to reinvest but can't find anything in the next expiration month you really like. A week later, with only three weeks to go before that next expiration, you might be surprised at some of the opportunities that surface for either that month or the next one out.
Although some people find it difficult to take what might be considered such a short-term perspective, it has some key advantages:
If you have idle funds or extra buying power in your account, there is nothing wrong in putting on a covered write just a week or even a few days before option expiration. Some people, however, sell out-of-the-money calls on the last trading day before they expire without buying or owning the underlying stock, reasoning that with expiration so near, they needn't incur the expense and risk of owning the shares. This is a temptation you should resist. True, calls on volatile stocks can carry premiums of 0.10, 0.20, or more with only a few hours of trading left and the stock selling below the strike price. But unless you buy the underlying stock, these are considered naked calls, even if you write them only a day before they expire. This would represent an account violation if you aren't approved for naked call writing. In addition, you won't be happy if big news about the company is announced after the close that day, causing you to be assigned on stock you don't own, and which subsequently opens much higher on Monday morning.
The only real consequence of a short-term approach is that you will pay more commissions, since you are writing more often. How much of an impact this will have on your returns depends on the fee structure of the brokerage you use.
Despite the fact that call writing reduces risk, it still entails risk.
After you buy a stock at $37.5 and sell a 40 call, the share price is as likely to drop to $35 as it is to rise above $40 by expiration. This is a fact of life for stock investors and does not change when you write calls. The calls do smooth the net effect of these fluctuations, but they do not affect the chances of them occurring.
When trading is halted on a listed option, holders still have the right to exercise, and writers must fulfill their contracts. You cannot, however, go into the marketplace and close out your position. A trading halt is typically a temporary situation and not a major problem for covered call writers. Option holders, on the other hand, can be forced to exercise if they are unable to sell their options in the open market. Consider the following, somewhat extreme, example: You own XYZ stock and have written the March 55 call. It is Thursday before March expiration and a hostile takeover offer has been made for XYZ at $60. Trading in the stock is halted at $53 and does not reopen on Friday. Heavy speculation will occur on the upside, but until the stock trades, holders of the XYZ March 55 call will not know whether or not to exercise. If they feel the stock will open on Monday above $55, the holders will want to own it and will have to exercise. Otherwise, the call will expire worthless. On the other hand, they may feel the stock will settle back first, giving them time to buy it below $55 on Monday or whenever trading reopens. Some holders may thus choose to exercise while others may not. That means you may be assigned or you may not. Either way, though, the situation has not hurt you, except that it prevented you from closing your position before expiration.
If you do your covered writing in a qualified retirement account, such as a self-directed Individual Retirement Account (IRA), you don't have to worry about any of the tax consequences (which makes it an appealing place to use the strategy). But if you use a regular taxable brokerage account, you'll have the extra burden at tax time of having to account for all of your stock and option transactions in the prior year. In addition, you'll need to be aware of some special tax rules that apply to covered writing. This section looks at those rules. Bear in mind, though, that tax rules can change. Also, you may be affected by other more broadly directed tax rules beyond those mentioned here. We advise that you consult the latest IRS documentation or your tax adviser before filing your taxes. And if you're considering a strategy specifically designed to defer taxes, consult a tax adviser before implementing it.
If the option you wrote is assigned, then the option becomes part of the stock transaction for tax purposes. For a stock held less than a year when you're assigned, taxing the option and stock together is no different from taxing them separately, since all short term gains and losses are combined when you file, anyway. But if the stock is already a long-term holding, it could make your call long term as well. (Additional rules governing this situation are explained in Table 4.6.)
If, when a covered call is written, the option is nonqualified and the stock is not yet long term, the holding period of the stock is eliminated entirely while the call is in place; the holding-period clock must therefore start over at zero when the call is closed. If a covered call option is qualified, then the holding period of the stock is suspended while the call is in place; in other words, once the call is closed, the clock can pick up where it left off.
With these rules, the IRS is preventing investors from executing essentially no-risk tax strategies using call options but still allowing tax-deferral strategies when the call writer's positions are at risk. Thus, you can write out-of-the-money covered calls to defer taxable events on your portfolio, either to benefit from long-term capital gains rates or to push a tax liability into the next tax year.
Say you write an August 45 call on 100 shares of General Motors stock that you have held for 20 years, at a very low cost basis, and are later assigned. You inform your broker that you want to buy 100 shares of GM at the current market price, which happens to be $46.30, and deliver those shares against your assignment instead of your 20-year holding. You further instruct your broker to mark the confirmation for the sale of 100 shares via assignment with the remark “versus purchase of 100 shares at $46.30” and add the date. In this way, the 100 shares you buy in the market will be paired up with the sale of 100 shares via assignment for tax purposes, giving you a cost basis for the transaction of $46.30, and you still own your original shares, with the 20-year holding period intact.
One of the key attractions to call writing is the flexibility to implement the strategy in different ways, thereby tailoring it to individual situations. The strategy thus provides very attractive benefits in lowering risk and volatility in equity portfolios, but also requires more work and attention than simply holding stocks, and will carry different emotional characteristics than simply owning stocks. The strategy, therefore, is not particularly appropriate for investors or managers who are not able to perform the additional tasks associated with implementing and monitoring the strategy on an ongoing basis. Indeed, the practicalities of monitoring dozens or perhaps hundreds of individual client portfolios is a deterrent to the widespread use of call writing by many portfolio managers.
That said, call writing is not difficult to implement in an individual account, nor does it add additional risk, even if not monitored closely. The worst case for those who initiate call writes and fail to monitor them is the possibility of having the stock called away when you might prefer to hold on to it.
Follow-up action may provide a way to even improve upon the basic strategy or tailor it to specific needs, opportunities, or market conditions, making call writing an ongoing investment management program that can provide benefit in almost any environment.
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