CHAPTER lll - LONG STOCK PART 4 [Selling Covered Calls] - Hot Topic

Since this is a hot topic, please allow me to share a few words...

The concept of selling a covered call is what I perceive to be an extremely helpful way for investors to strategize their portfolio with little to no risk. The concept in itself is relatively straightforward, the application of this strategy is the pitfall -- many new investors get too sucked into the idea of the amazing benefits of selling a covered call (which are all valid btw), they often overlook the limitations which is attached to this strategy.

It is therefore imperative for me to share a couple of profound tips with you before we get into the theory behind a covered call. In my view, a covered call would only truly work well in either one or more of these scenarios:

- You have a decent size capital (at or above $100,000)

- You own stocks which are now trading at least >10% above your original entry price

- You do not baghold stocks which are down >20% below your original entry price

- The stocks which you currently own are established tickers and not meme stocks

These are all the key concepts I share in my Options Beginner Class.

For implied reasons stated above, this is the exact reason why I share to my community:

- Never Sell Naked Calls (unlimited risk and limit reward)

- Never Sell a Covered Call with a Strike price below your stock entry price

It takes an experienced options trader/investor to share this insight; I am one of those people -- my biggest loss (and lesson till date) today is a loss of $7,000 selling naked calls on a stock. I obviously don't want this happening to you and would caution against anyone who encourages you to do otherwise.

On the topic of selling options, some people like to think of the "Wheel" Strategy as being the "fool-proof" strategy as well; basically oscillating between selling a put and selling a call, which is definitely not 100% effective as what most people make it out to be (if you consider the capital needed, the worst case scenario and the limitations of such a strategy).

Coming back to the topic of Selling Covered Calls --

The truth of the matter is, selling covered calls as a strategy is a "rich" peoples game. If you are a newbie just starting off with investing, you have an account which is in the $10,000 range -- my suggestion would be to entirely forgo even contemplating utilizing this strategy for now. That being said, proceed to learn the mechanisms behind this strategy so that when you do get a bigger portfolio in future, you are ready to apply this strategy to its fullest benefit. My article below will provide the concepts, insights and illustrations needed for you to fully internalize this - Enjoy.

SELL COVERED CALLS

A covered call position is created by selling a call against an existing stock holding. By selling the call, you get a premium and must sell the shares at the strike price if you are assigned the short call. The greatest profit from selling a call option against a stock position is the difference between the strike price and the stock's acquisition price plus the premium received. For instance, if you acquire EBAY at $98 and sell a $100 Call for $3.00, your maximum profit is $5.00 if EBAY closes at $100 or higher. If EBAY is trading at $101, the stock will be called away at $100 for a profit of $2.00 on the shares plus the $3.00 premium obtained from selling the call. The disadvantage of this strategy is that the position will earn a maximum of $5 regardless of how high EBAY rises before expiry, since selling the $100 call establishes an obligation to sell EBAY at $100. (Figure 3.11). Using a put, you may purchase the right to sell your long stock position at a certain price if you decide to sell at that price. If you are willing to sell the stock at a certain price and can be compensated for doing so, then selling a call is a reasonable trade adjustment. You accept the responsibility to sell the stock at the strike price of the short call if the option is in-the-money at expiry and get the call premium in exchange. The extra advantage is that if the stock is not in the money at expiry, the premium is retained as additional revenue and the stock position is maintained. These qualities of selling calls against a long stock position may be used to boost returns and perhaps offer a minor hedge against the position. The sole disadvantage, which is by no means insignificant, is that the short call does not protect losses in the event that the stock begins to decline. A minor decline in the price of the stock is somewhat offset by the premium earned. Nonetheless, if the stock falls significantly, this cushion is analogous to using a pillow to prevent the collapse of a piano. All sellers of covered calls should be aware of this risk.

STOCK MOVES HIGHER

You acquired 100 EBAY shares at $100 per share, and the price has now increased to $110. You do not anticipate the stock to climb much higher, or you expect it to continue sideways for some time, therefore you are ready to sell it at $110 for a 10% profit. Your first choice is, of course, to sell the stock for $110 and pocket the profit. Selling a call against your position will oblige you to sell the stock at $110 and allow you to receive a premium.

Assume a $110 EBAY call is trading for $2.50 each month. You may earn $2.50 by selling the $110 call. If EBAY is higher than $110 at the time of expiry, your shares will be called away at $110, which is the price at which you would be willing to sell the stock. If EBAY is higher than $110, you will earn $12.50, which includes the $10.00 profit from the sale and the $2.50 premium from selling the call. The disadvantage is that your upside gain is limited at $12.50 regardless of how high EBAY rises before expiry since selling the call obligates you to deliver EBAY at $110 regardless of what.

As a result, before selling the call, you should be comfortable with selling EBAY at the strike price and not anticipate the stock to climb much higher, trading sideways. If you believe EBAY will continue to rise significantly, it is preferable to just hold the stock rather than sell the call.

If you sold EBAY for $110, you would get a $10.00 profit and a 10% return. You may make a profit of $12.50 by selling the call at $110 and receiving $2.50 in premium, which is a 25% increase over the profit you would have made without selling calls! This profit increase is earned in return for forfeiting all future profits if EBAY rises beyond $110. If you are satisfied to sell EBAY at $110, you should be prepared to lose money if EBAY rises to $115 by expiry. Figure 3.12 shows the profit profiles of EBAY stock when compared to selling the call and establishing a covered call position.

The covered call position, as shown in Figure 3.12, has a higher profit profile until EBAY reaches $112.50. Above this price, the covered call position's profit is limited, whilst the long stock continues to benefit. Simply add the option premium earned to the strike price to arrive at this comparative point. Until this time, the covered call position has always outperformed the long stock. If EBAY is trading at $105 at the time of expiry, both positions will profit $5.00 on the stock, but the covered call writer will also profit $2.50 on the $110 call, which will expire worthless.

Even if EBAY is less than $100 at the time of expiry, the loss on the stock under the covered call position will be reduced by the amount of the premium paid, resulting in a minor hedge against the stock's downward trajectory. The premium received lowers EBAY's breakeven mark from $100 to $97.50 under the covered call. Selling a call not only raises your potential profit from selling the stock, but it also protects you from some adverse price movement. As a result, while considering whether to sell a covered call, you must consider the probability that the stock will rise over the reference point. The more improbable it is that the stock would rise over that level, the better the decision may be to sell.

If the stock's price falls before expiry, you have an interesting option. The short call expires worthless, and you retain the $2.50 premium. Selling the call increased the value of your stock holding. You might now sell the shares or sell another call for the following month. If EBAY falls below $107 before expiry, you may either sell the stock for $9.50 ($7.00 on the EBAY gain + $2.50 call premium) or sell another call at $110 for the following month. If the EBAY $110 call for the next month is trading at $2.75, you may sell it to get an additional $2.75 in revenue from your EBAY investment. If EBAY trades over $110 by expiry and you are assigned and compelled to sell your shares at $110, you would earn $15.25 ($10.00 in price appreciation + $5.25 in total call premiums received). Alternatively, you sold eBay for $110 and earned $2.50 in the first month and $2.75 in the second month. If EBAY remains below the strike price at expiry, you may continue to sell calls each month to generate more revenue and boost your profits on a company that is effectively trading sideways. Eventually if you are called out of your shares, your return is much higher than if you just sold the stock at $110.

Another advantage of being able to continually sell calls against your long stock position is that the additional revenue continues to lower your breakeven point. After one month, you decreased your breakeven threshold from $100 to $97.5. The sale of an additional call option in the second month decreases your breakeven point to $94.75. At this price the loss in the stock is covered by the short call premiums received. Remember that selling a call does not offer a full hedge against a decline in the stock's price; it only provides a partial hedge.

It goes without saying that one should not sell calls against a stock that you are not ready to part with. If the stock climbs higher and you wish to hang on to obtain the advantages of stock ownership (i.e., dividends) or prevent short-term financial gains, then selling calls is not appropriate because they result in the need to sell the shares. If the stock moves over the strike price, the only method to remove the obligation before assignment is to spend money to acquire back the short call. However, avoid selling covered calls if you have no intention of selling the covered stock. STRIKE SELECTION After a stock price increase, it is simple to determine the optimal strike price for selling covered calls. The selection of the striking price is based on two criteria: the desired sales price and the possibility of the stock advancing over the "comparison point." Choose a price at which you are willing to sell the shares as the strike price. If the stock has made a substantial upward rise, at-the-money strike prices are the optimal option. Depending on the time to expiry (described in the section that follows), at-the-money calls may still have considerable premiums, and the strike price should be an appealing exit point if the underlying stock has made a solid upward move. In the EBAY example, you picked the ATM call with a $110 strike price since $110 was an excellent exit point considering that you purchased $100 for the stock.

The comparison point is a second factor to consider with at-the-money calls. If you believe the stock might still rise much above the comparison point, selling at-the-money calls could limit your return on a company with more growth potential. If you believed there was a strong probability that EBAY will go over $112.50, selling the $110 call for $2.50 would significantly reduce your potential earnings. Imagine how unpleasant it would be to see EBAY climb much over $112.50 as projected, knowing that you sold a call at $110 and are thus not partaking in this upward trend. Out of the money calls should be considered if you expect EBAY to continue to rise beyond the comparison point. The premium collected is lower, but you have more opportunities to participate in the stock's upward trend. At the same time, the partial downward hedge is lowered since less premium is collected. This is the old-fashioned risk/reward tradeoff in covered calls—higher profit potential implies less downside hedge, and greater downside hedge means lesser upside profit potential. Because the premium decreases as you go farther out of the money, it is ideal to sell calls within one strike price of the at-the-money calls. If a stock is between strikes, sell the call at the next strike above the stock price.

Assume you sold the 1-month $115 out of the money call on EBAY for $0.95. Although the premium collected is lower, the comparison point has increased to $115.95 ($115 strike price + $0.95 premium). As a result, until EBAY reaches $115.95, the covered call position will beat the long stock. If you believe that EBAY will rise to $115 from its current price of $110, selling the out of the money call is better than selling the $110 call. As seen in Figure 3.13, there is a balance between possible profit and loss between the two options, and the best one relies on your EBAY price movement assumptions. The greater the likelihood that the price of EBAY will continue to grow, the better it may be to sell the out of the money option rather than the at the money option.

IN THE MONEY CALLS The above reasoning raises the issue of whether it is ever appropriate to sell an ITM call against a stock holding. Keep in mind that the strike price of an ITM call is lower than the stock price. If you sold an ITM call, you would be required to sell the underlying stock at a price lower than the current market price. In general, you should never be compelled to sell a stock at a price lower than its current market value. Of course, when you sell an ITM call, you will get a premium that covers the difference between the stock price and the strike price (i.e., the intrinsic value of the ITM call), as well as a time value premium based on the amount of time before expiry. For example, if EBAY is trading at $110, a 1-month $105 call contract may be selling for $6.00. As a result, if you sold the $105 call and were assigned, your actual selling price would be $111 ($105 for the stock plus the $6.00 premium). The deeper ITM the call, the smaller the time value premium and the closer the actual selling price is to the current market price.

Why would you sell an in-the-money call if the difference between selling it at the current market price and selling the call is so small? Assume you purchased EBAY for $100 and it has now increased to $110. You are concerned that EBAY's price trend may reverse, but you do not want to sell the stock just yet. Perhaps you should keep the stock for another two months to prevent short-term financial gains. There might be a variety of additional reasons why you decide not to sell the shares at this time. What matters is that you do not want to lose the unrealized profit if EBAY falls.

Because you don't want to sell the shares right now, the simplest change seems to be to add a protective put to hedge the position and lock in a sale price. Adding a protective put, on the other hand, requires a capital investment and decreases your unrealized profit by the amount of the premium. Assume you don't want to invest any more money, or if your stock position is substantial and purchasing defensive puts would involve a huge cash expenditure. You still have a choice with the freedom of alternatives. You may postpone the sale of the shares by selling ITM calls to lock in your unrealized gain. Let's explore how this works with your current EBAY stock position.

A 2-month EBAY $100 call is selling at $11.50 with EBAY at $110. The premium has an intrinsic value of $10.00 and a time value of $1.50. If EBAY is trading at $100 or above at the time of expiry, your covered call will be assigned, and you will sell your shares for an effective price of $111.50 ($100 strike price + $11.50 premium).

Even if EBAY lowers back to your initial purchase price, you guarantee a minimum profit. Furthermore, even if EBAY goes below $100, you still guarantee a profit until your breakeven point, which is presently $88.50. The loss in the stock position is compensated by the profit in the short call premium at $88.50. The profit/loss profile of eBay and selling the $100 call are shown in Figure 3.14.

As a result, selling the deep ITM call may ensure a minimum profit, providing the stock is above the strike price at expiry, while also significantly lowering your breakeven point and allowing for profit even if the stock falls below your initial buy price. You wait until you are allocated on the short call before selling the shares. Because the option has deep ITM, the odds of getting assigned early are substantially greater, and you may not be able to control when the stock is sold altogether. This is the risk associated with selling deep ITM calls. However, if you are allocated early, you still make money from your position, and turning an unrealized profit into a realized profit is always a positive thing. The apparent tradeoff is that you are no longer able to profit from EBAY's upward rise since you are compelled to sell the shares at the short strike price.

It may seem unusual to utilize deep ITM calls to delay the selling of a stock, given that deep ITM calls have the highest risk of early assignment. This is one of the downsides of employing deep ITM calls, so after you have sold the covered call, you must actively monitor the time value premium to see whether early assignment is viable. However, there is a method to prevent premature assignment. Due to the fact that the time value premium diminishes most rapidly in the last 30 to 45 days of an option's life, you may sell a covered call with an expiry date that is one or two months past your holding period. This will guarantee that before your minimum target date is reached, there will be sufficient time value on the deep ITM calls that you sold to reduce the likelihood of early assignment. Once the target date is achieved, time value will begin to depreciate more quickly, and if the option is still ITM, early assignment will be more probable and acceptable since the minimum target date has passed.

A significant benefit of selling the deep ITM call as opposed to buying the protected put is that there are no extra margin requirements. This is in addition to the fact that the put needs you to spend more money, while selling the covered call generates premium. Consequently, the collected premium might be invested in another asset. Remember that one of the advantages of the call replacement method was getting your realized profit and initial capital expenditure off the table by selling the stock so that you could invest those money elsewhere. Selling deep ITM calls gives a comparable advantage in that it enables you to realize your unrealized gain from the company's price increase in addition to the time value premium from selling the option without selling the underlying stock. Although you do not get the present value of your original capital investment, you do receive the present value of your unrealized profit. A dollar now is always worth more than a dollar in the future, thus it may be advantageous to have access to the profit sooner rather than later. In other words, the stock is not yet sold, but the unrealized profit is used. You may invest the $11.50 call premium, which represents your profit, in future option transactions or, if the quantity of options sold was substantial, you can simply park the cash in T-bills or a money market account and collect interest on your profit without selling the stock. Thus, selling deep ITM calls may bring substantial gains despite the fact that it stops you from benefiting in EBAY's further price appreciation. TIME TO EXPIRATION

The time to expiry of a covered call is critical in terms of the time value premium connected with the calls. Naturally, the time value premium on options increases as the expiry date is longer. However, since you cannot predict when a call will be assigned and the long stock will be sold under the covered call, selling longer period calls postpones profit realization until a later date. Furthermore, selling calls with a longer time to expiry allows the stock to rise higher and deeper ITM. The covered calls limit your profit regardless of how high the stock rises. In other words, although the premium for longer-term covered calls is bigger, the stock might also burst and quadruple in value over that time period, preventing you from participating in such a significant price move upward.

Let us revisit the EBAY case to explore these elements in determining time to expiry. You bought 100 shares of EBAY for $100, and it has now increased to $110. Assume the following option pricing if you want to sell ATM calls:

Because it offers the greatest premium, the 4-month call seems to be the most appealing to sell for a covered call. The advantage of utilizing the 4-month call is that you may receive a hefty premium and more than double your profit from selling EBAY for $110 (plus the $6.75 premium). Because of the higher premium received, you also obtain a greater partial downside hedge if EBAY falls dramatically. The disadvantage of having longer time till expiry is that EBAY has more time and a larger probability of making a major move higher or lower. With so much time till expiry, EBAY's price might fall dramatically, resulting in a losing position. With longer time, there are greater chances for price shocks, which might cause EBAY to fall swiftly and harm the position. With less time till expiry, the position has less opportunity to move against you.

Because your profit is limited to $16.75 (stock profit of $10 + $6.75 call premium), it would be wasteful to lock up your funds for 4 months to allow EBAY to go to $130. In other words, why allow EBAY so much time to go much higher if you're going to restrict your return unless you're convinced EBAY won't be much higher than $117 at expiration? Another disadvantage of utilizing long-term options is that you must wait a long time for the option to expire and so realize your profit. Even if EBAY remains sideways at $110 for the foreseeable future, you will most likely have to wait the entire four months before achieving your maximum profit potential. SCALING-OUT STRATEGY

When dealing with huge stock positions, you may not want to sell the whole position at once. You may sell a few calls each month to gradually exit the investment, a few hundred shares at a time. You may sell calls every month until the whole position is called away, generating in more and more premium revenue. Furthermore, if you continue to sell calls at higher strike prices, you will be partaking in the company's upward rise and generating a greater profit, which you would not be able to accomplish if you write covered calls for the whole stock position in one month.

Assume you own 1,200 shares of EBAY at $100 per share, and 1-month EBAY $105 calls are priced for $2.75 per share. Sell four EBAY $100 calls to cover 400 of the 1,200 total shares to begin the scaling-out plan. If EBAY is worth $106 at the time of expiry, 400 shares may be called away for a profit of $7.75 per share ($5.00 stock profit + $2.75 call price collected). The remaining 800 shares are still fully participating in the stock's upward movement and have an unrealized profit of $6.00 per share.

If the following month's $110 call options are selling for $2.50, you may sell four more $110 calls to cover the remaining 400 shares. If EBAY is trading at $112 at expiry, the 400 shares will be called away at $110 for a total profit of $12.50 ($10.00 in stock profit + $2.50 in call premium).

With 400 shares left, you might sell the $115 Call option for $2.50 in the next month. If EBAY's price is more than $115 at expiry, the last 400 shares would be sold for a profit of $17.50 ($15.00 stock profit + $2.50 call premium received).

Assuming EBAY was trading at $116 at the expiry of the previous set of covered calls, let's examine the gains from scaling out of EBAY by selling 400 shares of EBAY at expiration each month and scaling them out over the course of three months using covered calls. 400 shares of the stock would have been sold the first month at $106 ($2,400 profit), another 400 shares would have been sold the second month at $112 ($4,800 profit), and the last 400 shares would have been sold at $116 ($6,400 profit) for a total profit of $13,600. Under the scaling-out technique, the profit on the first 400 shares is $3,100 ($7.75 profit x 4 contracts). The profit on the second 400 shares is $5,000, while the profit on the last 400 shares is $7,000. The total profit generated by the scaling-out method is $15,100, which is 11% more than the profit generated by just selling shares every month. Consequently, employing covered calls while scaling out might increase your total profits.

At first appearance, the extra profit generated by using covered calls to expand out does not seem to be substantial. Some may argue that it would have been preferable to just keep all 1,200 shares and sell them at a high price for a larger profit. However, you assumed that EBay's monthly price would exceed the strike price. Assume that EBAY's price was $104 at expiry after the first month. You would retain the $2.75 premium obtained from selling the $105 call options, and you would continue to own the 1,200 shares. Therefore, you may sell four more calls at $105 per contract for the next month. Assume that the in-the-money $105 calls are trading for $4.00 per contract. You may sell an additional four calls for a total of $4.00 in premiums, in addition to the $2.75 previously earned. If EBAY is trading above $105 at expiry, these 400 shares will be called away at $105 for an effective selling price of $111.75 ($105 strike price + $6.75 in total call premiums received). If EBAY's share price remains around $105 at expiry, you may extend the term of your short calls and receive further premium. By scaling out you can continue to sell calls because the entire stock position is not called away at once as it would be if you sold 12 calls at once. You may continue to sell partial covered calls each month and receive additional premium if EBAY is slowly rising up or trading sideways.

If the options expire without value, you will still own the entire quantity of shares and benefit from the sale of call options. Only 400 shares of stock will be called out of your position if the company is trading above the strike price at expiry, leaving you with 800 shares to either let run higher or sell additional covered calls with. Additional earnings from scaling out by selling covered calls might be pretty considerable if you can continue the method across many months. If EBAY begins trading downward, the premiums you get might help mitigate part of the loss until EBAY either recovers or you are called away from all 1,200 shares.