IMPLEMENTING COVERED CALL WRITING
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.
Follow-Up Actions
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.
The
Simple Case: Doing 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.
Closing
Part or All of the Position
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.
Rolling
Options
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.
Rolling
Up
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.
TABLE 4.1 Pricing Scenarios on DEF Calls
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
|
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.
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.
TABLE 4.2 Rolling Up
|
Original
Scenario
|
New
Scenario
|
Premium received (in points)
|
2
|
2-3 + 1 =
0
|
Maximum potential stock gain (strike
price less initial stock price)
|
30-28 = 2
|
35-28 = 7
|
Total potential gain from stock and
options
|
4
|
7
|
Breakeven stock price (initial stock
price less premium earned)
|
$26
|
$28
|
Time period
|
Feb
expiration
|
Feb
expiration
|
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.
Rolling
Up and Out
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.
TABLE 4.3 Rolling Up and Out
|
Original
Scenario
|
New
Scenario
|
Premium received (points)
|
2
|
2-3 + 3.5
= 2.5
|
Maximum potential stock gain (strike
price less initial stock price)
|
30-28 = 2
|
35-28 = 7
|
Total potential gain from stock and
options
|
4
|
9.5
|
Breakeven stock price (initial stock
price less premium earned)
|
$26
|
$25.5
|
Time period
|
Feb
expiration
|
Apr
expiration
|
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.
Rolling
Down
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.
TABLE 4.4 Rolling Down
|
Original
Scenario
|
New
Scenario
|
Premium received (points)
|
2
|
2-0.35+2
= 3.65
|
Potential gain from stock (strike
price less initial stock price)
|
30-28 = 2
|
25-28 =
-3
|
Total potential gain from stock and
options
|
4
|
0.65
|
Break-even stock price (initial stock
price less premium earned)
|
$26
|
$24.35
|
Time period
|
Feb
expiration
|
Feb
expiration
|
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
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:
- Rolling:
The process of closing the short call position in a covered write and opening
(substituting) a different covered call position on the same stock.
- Rolling up: Substituting a call with a higher strike price.
- Rolling down: Substituting a call with a lower strike price.
- Rolling out: Substituting a call with a more distant expiration.
- Spread order: A single order that involves both a purchase and a sale of
options of the same type on the same stock for a specified “net” price.
By accepting such an order, your brokerage firm guarantees that both sides will
be executed together as long as your net price can be met. Otherwise nothing is
done. Covered writers frequently use spread orders to roll their option
positions.
- Net price: The combined price of a two-sided transaction involving the
purchase and sale of either two options or a stock and an option.
- Net credit: If the price of the sell side is greater than the price of
the buy side, then the result is a net credit.
- Net debit: If the price of the purchase is greater, then the result is
a net debit.
Other Considerations
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.
Behavioral Issues
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.
Differing Approaches
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.
Incremental Call Writing
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:
- Increasing income. You hold a stock that you picked up at $28 and that has
traded between $20 and $40 over the past 18 months. The share price is now $30.
You have finally decided that if the stock gets back up to $35, you’re going to
take your 25 percent gain and sell it. Once you can say that to yourself, this
becomes a covered write candidate.
- Establishing a target price. You have a stock that tends to trade
in a range, and it is currently near the top of that range. Rather than sell
your shares while they are high, hoping to repurchase them later, at the bottom
of the trading range, you might find a call option with a strike above the
current share price and take that premium in as income. Say that, as above, the
trading range is $20 to $40 and that the stock price is now $38. You might sell
a call with a 40 strike. If the stock pulls back, you get to keep the premium.
If it breaks out of its range on the upside and exceeds $40, you could let it
get called away or roll the option out and up to a higher strike price.
- Reducing volatility. You hold a substantial number of stocks on which there are
listed options and would like to reduce the volatility of your portfolio by
bringing in income on some positions. Or you may simply feel that the market
will remain relatively flat for some time because of the overall economic
climate.
- Long-term holdings. You own a stock that you may have inherited or simply held
for a very long time. It has low cost basis and you prefer not to sell it, but
it’s been languishing as a performer. You can write OTM calls on the position
for additional income and minimal risk of assignment.
Traps Involved in Writing for Incremental
Return
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:
- Writing calls at the wrong times. Incremental writers tend
to write calls intermittently, based on a stock’s past behavior rather than on
its anticipated behavior. An example of this is writing calls on a stock that
has not moved appreciably in some time. If the stock has been relatively flat
for several months, its volatility, and hence the premiums of calls written on
it, will be somewhat lower than usual. If it continues flat, then writing a
call could prove beneficial, but if it breaks out of its doldrums on the
upside, you may have given up some of that upside for a lower-than-usual amount
of call premium.
- 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.
Believing you can time the market. If
you sell calls only when you “feel it is safe” (that
is, when you believe your stock won’t rise enough to be called away), you are
in dangerous waters. Few people succeed at this assessment consistently over
time, particularly if they are operating largely on gut feelings. Say you buy a
stock at $40 because you believe it will be priced between $60 and $70 in a
year or so. Six months later, the stock is trading at $46. You decide that at
the rate it’s been moving, you can write a two-month call option at a strike
of 50 for, say, 1.50 and not have to worry about your shares being called away.
One month later, the stock breaks out and runs to $54. Stocks rarely exhibit a
nice steady increase each month just to accommodate your strategy. So, your
stock is on track to achieve your long-term objective, but you have given up
any appreciation above $50 for another month. You can recapture this
appreciation by rolling up and out, but the point is that you tried to time the
market with your covered write and it did not work to your benefit. Meanwhile,
you elected not to write during the first six months, when you could have taken
in premiums at the 45 or 50 strike prices without being called away.
The Total Return or "Buy-Write"
Approach
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 re-establish 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.
Traps in the Total-Return Approach
Like the incremental-income approach,
the total-return approach also has its traps. Key among them are the following:
- Writing the highest premium. If you are looking for covered writing
opportunities, you will see numerous situations in which option premiums appear
exorbitant and offer highly attractive potential returns. The problem is that
very often these candidates are highly volatile stocks or stocks that have
speculative fever built into their prices. High premiums can have any number of
causes. They may even be a bearish indicator. When there is the possibility of
a downside move—say, in the event the company is named in a substantial
lawsuit—put options are likely to increase in value as large stakeholders buy
them to protect their positions. In such situations, arbitrage among the puts,
calls, and the underlying stock will generally cause the call premiums to rise
as well. In other words, the calls increase in value as a result of the
likelihood that the stock will decline. If you go after these situations, you
may be in for more of a ride than you bargained for.
Too much focus on the option, not
enough on the stock. When writing covered calls, it’s easy to lose sight of the
fact that the stock is your main investment and that it holds virtually all
your downside risk. An attractive premium should always be evaluated in
relation to the underlying stock’s prospects. You should keep in mind that if
the share price declines, you can lose money despite the premium income
(although still less than if you owned the stock by itself). This typically
occurs with volatile stocks that have options two or three strike prices above
the current share price whose premiums seem high. Say such a stock is trading
at $46 and you can get 1.50 for a two-month call at the 55 strike price. This
may provide a whopping return if exercised, but it will not offset the downside
risk of the stock trading below $44.50.
Unrealistic expectations for returns if
exercised. When looking for covered writes and ranking them by potential
return, you will see some with huge potential RIEs. This can occur with any
highly volatile stock that has call options with strike prices well above where
the shares are currently trading. The calls often provide attractive premiums
while still allowing significant upside gains on the stock before being
assigned. It is easy in such situations to lose sight of the fact that volatile
stocks present greater downside risk as well. In the example above, the return
if exercised for the 55 strike call would be 22.8 percent ($9 on the stock plus
$1.50 for the call, divided by the purchase price of $46) in two months. Sounds
terrific. But what is the reasonable likelihood of the stock reaching that
strike price in 60 days? The return if unchanged on this position is only 3.2
percent.
Not writing continuously. Total-return
writers can fall into the same trap incremental writers face—that of trying to
guess when to write and when not to. If you buy a stock because it represents
an attractive covered write and then decide not to write another call when the
first one expires, you are defeating the purpose of selecting that stock to
begin with. Even in the above example, where the static return was 3.2 percent,
by not writing that call, you would be losing out on premium that annualizes to
more than 19 percent. The same observation holds for situations where you are
assigned but do not reinvest your proceeds in a new position right away.
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.