Investing for retirement, general financial advice and lessons learned, and occasional opinions on anything and everything.
Wednesday, July 24, 2013
Nice Covered Call Example
I don't do much option trading, but I'd like to start writing covered calls and puts on certain stocks. Stocks trading at high valuations, or trading sideways for long periods tend to be good candidates for covered calls; where someone pays you a few bucks for the option to buy your shares in the future at a higher price than today. The risk to the me is that I will sell my shares at a higher price than today; thus, I'll part with my dividend producing asset.
Everyone loves to get something for nothing. When covered calls end up expiring worthless that is exactly what happens. The writer (seller) received money for the call premium. An option that goes unused means the seller ‘won’ without giving up anything.
Many people think that seeing short calls expire is the ‘best case’ result. They are wrong. To understand why simply do the math.
Assume we own 100 XYZ Corporation which now trades at $45 per share. Pretend the bid on the October $50 calls is $2. Selling one covered call contract at that price brings in $2 x 100 shares = $200.
If XYZ finishes at $45, unchanged from its inception date price, on expiration Friday:
We started with 100 XYZ shares worth $4,500. When the trade concluded we finished holding the original 100 XYZ shares, still worth $4,500, plus the $200 from the call premium = $4,700 in total value.
If the underlying shares had declined in price by anything greater than the $2 per share our position would have less total value than we started with as of the trade inception date.
The call money received was 100% profit. Did that really represent the maximum possible profit?
Consider the result achieved if XYZ ends at $50 or above on the option’s expiration date.
The call writer would be forced to deliver 100 XYZ shares when the option is exercised. The option owner would then pay him $50 x 100 shares = $5,000. The call seller would also have the $200 from the call premium received.
Final position = No shares + $5,200 of cash.
Total Value = $5,200.
Which would you rather have on the option expiration date… $4,700 or $5,200?
Sure, it rankles if the underlying shock shoots to well above the chosen strike. Call sellers have capped their upside. They will miss out on pocketing the full move. Do not sell covered calls at strike prices lower than where you would be willing to part with your shares.
The ‘risk’ in covered call writing is exactly the same one you take whenever you sell any stock. There is always a chance that those shares could go higher afterwards.
The key concept is simple.
Once you have sold covered calls … seeing the option exercised always delivers your best-case result.