Options Trading: Major Advanced Call-Writing Techniques

ADVANCED CALL-WRITING TECHNIQUES

This chapter turns to more sophisticated implementations of call writing, including the use of margin, employing underlying securities other than stocks, and partial or ratio writing.

Flexibility is unquestionably one of the hallmarks of covered call writing. If you own stock and are not writing options, things are black or white—you either hold your shares or you sell them. Covered call writing expands your follow-up possibilities to include a number of ways to hedge the stock, in terms of both the amount and the time period. It also enables you to adjust the risk/reward parameters of your positions, should either the stock price or the market conditions warrant it. This flexibility expands dramatically over time, since you can write new options once the initial ones expire or you can roll an existing position up or down or out before expiration. In this manner, you can control how much or how little of the total potential return you give up on the stock in exchange for a fixed premium, and you can change this amount each time a new call is written. From this perspective, a covered writer can actually use the options to drive the returns on the underlying stock position.

The following are discussed in this chapter:

• Participating in “hot” stocks, with lower risk and volatility
• Tax strategies
• Margined covered writes
• Writing against other securities
• Partial writing, mixed writing, and ratio writing
• Put writing
• Overvaluation
• Expiration
• Arbitrage

Writing Calls on "Hot" Stocks

If you like to “follow the action” and play hot (highly active) issues, you probably have experienced some serious bumps and bruises in your day. Frequently, the action involves a stock that has listed options, giving you an alternative way to participate without taking as much risk, or by modifying the risk in price or time.

The action in a given stock may be hot for a variety of reasons—possible merger or acquisition, large potential deal pending, earnings speculation, stock split, new product announcement, or rumors of all kinds. If you’ve participated in these types of situations, you know that some work out, but many do not. Most become roller-coaster rides regardless of how they ultimately turn out. Generally, there is speculation about a substantial move on the stock one way or the other. If an up move is what you’re looking for, a covered write might be well worth considering. You may not have as much ultimate upside potential as if you simply owned the underlying stock, but you may be able to get a very attractive potential return with much less risk, and you will have a greater likelihood of making at least some profit than the stock buyer. Sometimes, when the speculation continues for months with no big move, your comrades who bought the stock are suffering from anxiety while you’re pulling in option premiums.

Consider the case of InterMune (ITMN). The company developed and commercialized products for the treatment of serious pulmonary and infectious diseases and cancer. The stock, which had been as high as $52 in the preceding year, hit a low of around $16 in July 2002 before moving up to $20 in the next few weeks. In early August, call volumes and premiums began to rise precipitously. Rumors were circulating that the company would announce the results before Labor Day of clinical trials on a potentially lucrative new drug in testing. The company’s future could be so profoundly affected by the results of the clinical trials that the stock might either skyrocket or collapse, depending on whether they were favorable or unfavorable.

We looked at the stock when it was trading between $20 and $21 and decided that the premiums in the September call options made covered writes very attractive. We bought the stock at $20.80 and, at the same time, were able to get the almost unheard of price of 4.00 for the September 22.5 call (with one month to go before expiration!). That gave us a net cost of $16.80 for the covered write, enabling us to profit even if the stock dropped by 10 to 15 percent. For the next two weeks, the stock traded up to $22 and back to $18.

TABLE 5.1 Covered Write versus Stock Purchase for ITMN

Then, on August 28, the announcement came. It was good news, but not the blockbuster some had expected. By the end of the day, the stock was at $22.66, and the Sep 22.5 call was priced at 2.25. If the position was closed on those prices, the comparison of covered write to stock purchase for the period would look like Table 5.1 (excluding commissions).

Of course, anyone who actually purchased the Sep 22.5 call at 4.00 lost nearly half of the investment if he or she closed it on the day of the announcement.

Tax Deferral Strategies

Covered writing cannot eliminate a tax responsibility, but it can help you postpone one. Say you have owned a stock for many years and have a sizable capital gain on it. You wish to sell it, but it is late in the year and you would like to postpone your capital gains liability for another whole year. In the meantime, however, you are afraid the stock may retreat from its current price. Writing an in-the-money call option with an expiration in the next calendar year could provide you with the downside protection you need until after year end. You don’t want to go very far in the money with the call, however, because you do not want to risk having an early assignment that could negate your plan entirely.

Bear in mind that tax rules prohibit this practice until your stock position has exceeded the requirement to qualify as long term. If your position is still short term, then writing an in-the-money call could eliminate your existing holding period and restart the clock when the call is closed. You can, however, write an out-of-the-money call without incurring this restriction, although this may not provide you with as much downside protection.

Covered Writing on Margin

Buying stocks on margin enables you to increase your investment with money borrowed from your broker. This increase in your portfolio gives you additional leverage, which means you earn more when your investments gain but also lose more when they decline. The aim, of course, is to earn more on the incremental investment than you spend on the interest charged to borrow the money.

With low interest rates (say, 6 percent), you only need to identify covered writes that return more than 0.5 percent a month to come out ahead of a straightforward cash-only investment. This sounds easy, but bear in mind that margined portfolios decline faster than cash portfolios in a bear market. Their fall is exacerbated by the fact that margin calls force you to liquidate parts of the portfolio as prices drop. When many investors who have traded on margin are forced to do this, it helps accelerate market declines.

Margin Rules for Covered Writes

Since stock is the primary investment vehicle in covered writing, margining those stocks will give the covered writer a similar leverage enhancement, but with a distinct advantage over a stock owner: The option premium received from the covered write helps meet the margin requirement. The general initial margin requirement on a covered write when the option is out of the money is 50 percent of the stock price, less the option premium received (net of commissions). Thus, the more premium you take in for a margined covered write, the less money you have to put up to carry the stock, and the greater your leverage.

Taken to the extreme, it would even be possible to purchase a low-priced stock on margin and identify an in-the-money call option that, when written, would supply enough premium to pay for the entire 50 percent requirement to own the stock. But the brokerage industry does not want clients purchasing stock completely with borrowed capital, so it adopted an additional rule to limit the amount that can be borrowed on in-the-money covered writes. This rule states: When a covered write is in the money, the margin “release" (the amount a brokerage will loan you) is 50 percent of the stock price or of the strike price, whichever is lower. The intent of this rule is not to discourage margining in-the- money covered writes but to prevent them from being initiated completely with borrowed money.

TABLE 5.2 Comparison of Cash and Margined Covered Writes

* Returns are calculated using the net debit method. The maximum margin of 50 percent is used.

Even with this rule, you can still gain quite a bit of leverage by margining in-the-money writes. Also, you can frequently find out-of-the-money options in the more distant expiration months (particularly among LEAPS) that provide enough premium to reduce the net outlay for the covered write to a fraction of the stock’s cost. And these do not fall under the purview of the above margin limit.

To illustrate the leverage that margining gives a covered writer, Table 5.2 lists the potential returns of the following out-of-the-money covered write, implemented both with and without margin:

Buy 500 ZZZ at $11.

Sell 5 Oct 12.5 calls at 0.75.

41 days till expiration.

Margin rate = 7 percent.

Commissions excluded.

Note that the covered write on 50 percent margin increases the potential returns from this position not just by a factor of two, as you might expect, but by a slightly higher factor (46.5 percent versus 21.9 percent). The reason is that the investment required in the margin scenario is not 50 percent of the cash investment, but only 46 percent: The margin requirement is 50 percent of the cost of the shares ($5,500), or $2,750, less the premium received ($375); that comes to $2,375, or 46.1 percent of the cash investment of $5,125. As you sell calls with greater premiums relative to the stock price, this effect becomes more pronounced. The more option premium a covered writer receives, the greater the leverage when buying the underlying stock on margin. Because of this, covered writers can obtain even more leverage from margin purchases than stock buyers can.

An in-the-money example would show a similar effect, although your margin requirement, before being reduced by the call premium, may be  slightly more than 50 percent of the stock price, because of the rule mentioned. If you were to write the October call with a strike price of 10 instead of the 12.5 in the example above, the maximum your broker would lend you would be half the strike price rather than half the stock price—$2,500 instead of $2,750. Your net requirement, after subtracting the premium, would therefore be $2,625 instead of $2,375, or 51.2 percent of the cash investment. Writing in-the-money calls on margin can thus provide both attractive downside protection and attractive returns as a result of the leverage.

Advantages of a Margined Covered Write

The cash brought in from option premiums on the covered calls you write not only reduces your margin balance but also increases the equity in your account. This reduces your margin interest and helps cushion the account against the necessity of liquidating to meet a margin call should prices decline. Moreover, you can sometimes meet—or at least partially meet—a margin call by writing covered call options in the account rather than depositing additional cash.

Alternatively, the option premium you receive can allow you to purchase even more stock. In fact, a covered writer can sometimes acquire considerably more shares by using margin than a stock buyer can. That’s because when you write calls in a margin account, the premiums you receive increase your buying power by twice their value. So, by using margin, you can acquire up to twice as much stock as you have capital for, write options on that position, and use the cash from the options to buy even more stock. You can then possibly write even more calls. The leverage can be substantial.

Table 5.3 uses the following situation to illustrate how many more shares margin allows a covered writer to purchase than a buyer of the same stock.

In the margin scenario, the covered writer’s capital requirement per 100 shares is half the cost of the stock (or $550) less the option premium ($175). That means the net requirement is $375 per 100 shares, excluding commissions. With $5,500, the covered writer is thus able to purchase 1,400shares of stock ($5,500 divided by $375, times 100, rounded down to the nearest 100 shares). Margined covered writes with this much leverage are not uncommon.

TABLE 5.3 Maximum Shares That Can Be Bought in Cash versus Margin Accounts

 Example:

ZZZ stock = $11/share.

Out-of-the-money call on ZZZ = 1.75.

Available funds = $5,500 round lots only.

Commissions excluded.

The example in Table 5.3 illustrates the additional advantages that covered writers with fully margined positions have over straight stock owners. The effects are even more pronounced in this example because the stock is relatively low priced. These advantages, however, do not mean that you should necessarily leverage your self to the maximum or always use low-priced stocks. Using margin doesn’t have to entail taking a more aggressive stance. Margined purchases can be used for reasonably conservative strategies, such as helping to diversify a portfolio or enabling a smaller investor to buy more stable, higher-priced stocks. 

Covered Writing against Securities Other Than Stock

The standard terms of an equity option stipulate shares of the underlying stock as the deliverable item if assigned. Thus far, only calls covered by the underlying shares themselves have been discussed, but an equity option may be covered by an item other than shares of the underlying stock, if that item is readily convertible into those shares. That means you can write covered calls on warrants, convertible bonds, preferred stocks, or even other options, subject to certain qualifications.

Writing Calls against Convertible Securities

The first qualification is that your convertible security must convert into at least enough shares to cover your short call options. If, for example, you have a bond that is convertible into 25 shares of common stock, then you would need four bonds to cover one call option. The next qualification is that the convertible security cannot mature or expire before the option’s expiration date. In addition, if it has a specified conversion price into common shares—for example, a warrant for XYZ shares at $15—the strike price of the call you are writing must be the same or higher. These qualifications must be met for your brokerage to consider the convertible valid as coverage for the short call. If you have any doubts about whether a particular security qualifies, ask your broker.

Writing calls against warrants or convertible bonds is not very common, since not many such issues are available. Also, it is more challenging to find these situations, because these instruments do not show up in most of the software used to find covered writes. Bear in mind, however, that convertible securities have special characteristics you need to consider when using them in your covered writing program. Some convertible bonds, for example, are callable, meaning that they can be redeemed before maturity on specified dates at specified prices. That could have significant implications for pricing (the bond might not rise above the price of its call provision) and could present a problem if your bond is called while you still have a covered write associated with it. Also, securities like convertible bonds and preferreds may have long lives or pay interest, causing them to carry significant time value over their conversion value. In that case, it will not be to your advantage to convert if you are assigned on your short call, since you would give that time value up. You would be better served by purchasing common shares to fulfill your assignment and then either holding the convertible or selling it.

Writing Calls against Other Options—The "Call-on-Call" Covered Write

Covering calls with other options is much more popular than writing against convertible bonds or preferred stocks. Such positions are not called covered writes, however. In options lingo, they’re referred to as bull calendar call spreads or diagonal spreads. We prefer the term call-on-call covered write. However you label them, they work the same way as covered writes on stocks.

Typically, you would look for an in-the-money call to buy instead of stock. (Remember, the deeper in-the-money the call, the less time premium—and you want to minimize time premium, since it represents a cost to you in this strategy.) You need to select a call in an expiration month that is farther out than the expiration of the call you want to sell and with a strike price that is the same or lower. Otherwise, your brokerage firm will consider your short position uncovered.

The primary advantage of using an option as your underlying security rather than buying the stock is that you put up a lot less money. If you want to write a covered call on IBM when it is selling at more than $80 a share, you have to pay more than $8,000 for one round lot of the stock. Even on margin, you would need to put up $4,000 (and pay interest). If, instead, you buy a five- or six-month call option on IBM that is around 15 points in the money, your investment would probably be well under $2,000.

TABLE 5.4 Covered Write against Stock and against Another Option

Note: Returns calculated using the net debit method.

* Assumes that the Jan. 65 call will be worth 18.10 at October’s expiration.

Your capital requirement in this case is governed by spread rules, which say that you must put up the difference between the option you purchase and the one you sell—that is, the net debit of the two positions. Essentially, that means that your long option is not marginable and must be paid for in full. To invest in spreads, you will need to be approved for the strategy by your brokerage firm and will be subject to a minimum equity requirement in your account (over and above the cost of the spread), probably equal to $10,000 or more.

Table 5.4 shows your potential returns from writing a call against a cash (non-margined) stock position, a margined stock position, and another option, given the following situation:

Buy 100LMN at $81.80.

or

Buy 1 LMN Jan 65 call at 18.90 (149 days to expiration).

Sell 1 LMN Oct 80 call at 5.40 (58 days to expiration).

Margin rate = 7 percent, and margin requirement = 50 percent of strike price ($4,000).

Assume no dividend in this time period. Commissions are excluded.

If you choose to write against the January call, when the October expiration comes around (or anytime before, for that matter), you can roll the October call or close the whole position, just as you could if you were writing against shares. You could write calls expiring in October, November, December, or even January while continuing to use the January call to cover them (as long as you are writing a 65 or higher strike price). The amount of time premium you are paying for the January call with the stock at its current price is only 2.1 ($210). This is the cost (if held all the way to January) of using a call option instead of buying the stock at this price. Just for comparison, the margin interest on $4,180, the maximum margin release in this situation, at 7 percent for 149 days would be $119.44.

Additional considerations apply when doing call-on-call covered writing. If you are assigned on your short position, you generally will want to sell your long option, as opposed to exercising it, if it has any time value remaining. To prevent being forced to take either action, investors who write calls against other calls are usually more attentive to the short side of their position, with an eye toward rolling or closing rather than waiting until the last minute to see if they will be assigned. And remember that when you cover with a call option instead of a stock, you don’t receive any cash dividends, should there be any, or have any voting rights.

It might seem riskier to write a call against an option than against a stock. Actually, the reverse can be true. Granted, if you take a much larger position because it costs you less to put on, your overall risk in absolute dollars would indeed be greater. But if you buy the same position and just put less money into it, your total downside risk on that position is lower, for the same potential dollar profit. A call-on-call writer has less total capital at risk than the holder of an equivalent number of shares. If LMN in the example dropped to $50, the stock owner would be down $3,180 on 100 shares, whereas the call-on-call writer would be out only the initial investment of $1,350.

When you use an option as a covering security, the time value in the long call position is an added cost, because it will decay to zero by expiration. But you can still expect to lose less money than the covered writer with stock if the stock declines in the near term. A long position in the stock declines dollar for dollar with the share price, but the long in-the-money call position loses less than a dollar for every dollar drop in the stock. That’s because the option picks up more time value as its strike price gets closer to the current price of the stock.

To see how this works, assume that LMN in the example above suddenly dropped to $70. The covered writer who owns the stock (whether in a cash or margin account) would have an unrealized loss of $11.80 per share. The call-on-call writer would lose less. An approximate theoretical value for the Jan 65 call a month into the period with LMN at $70 would be around 10, which puts the unrealized loss in the call at only 8.90. Although the option would lose as much as the stock if the share price was $70 at expiration, a call-on-call writer who closes out the position a month from now would lose less than a writer against the stock.

Covered Writing on LEAPS

As explained in Chapter 1, long-term equity anticipation securities (LEAPS) are equity options that are issued for long periods (one, two, or three years) and that always expire in January. (LEAPS on ETFs and on indices expire in December.) For the most part, LEAPS are available on large-cap stocks with actively traded regular options. Fewer strike prices are available on LEAPS than on short-term options, and their trading volume is usually lighter.

Since LEAPS are identical to regular options except for their longer expirations, they can be used interchangeably or in conjunction with other options to create various strategies. You can write a LEAPS option against a stock as a long-term covered write, or you can use the LEAPS option as a surrogate for owning the stock (as in call-on-call writing) and write a covered call against it.

Writing a LEAPS option against stock brings in a substantial amount of option premium, which in turn lowers your investment and provides leverage. If you write a one-year LEAPS option against a stock, you have the whole year to compound your returns from that premium. What’s more important, the premium you bring in can offset a substantial portion of your initial outlay for the stock. The premium received from writing an at- or slightly out-of- the-money LEAPS option against a relatively low-priced stock, for example, could be sufficient to cover nearly half the cost of purchasing the underlying stock on margin.

The more popular use for a LEAPS option in a covered write is as a substitute for the underlying stock. This works exactly the same way as writing on any other call option. The strategy is thus an implementation of call-on-call writing with a longer-term option as the covering position. Since you pay more in time value for a LEAPS option, what is its advantage over a shorter-term call? For one thing, the time value in the LEAPS option declines more slowly. For another, if you hold the LEAPS option for more than one year, your gains, if any, could potentially be taxed at long-term rates. In addition, since LEAPS options tend to be more sensitive to interest rates and volatility, at a time when both of these factors are low, a LEAPS call might represent an attractive long-term purchase.

You need to be aware, however, of several differences that exist between LEAPS and regular equity options. The decay in their time value, for instance, exhibits slightly different characteristics, such as accelerating when they have only six months to expiration. Also, an at-the-money LEAPS option might not gain much value even for a sharp upward move in its underlying stock. Consequently, it is conceivable that the gain on a LEAPS option would be less than the loss on a short-term option you write against it, thereby losing you money for the period, even though your stock went up.

For more information on LEAPS, see Lawrence McMillan’s Options as a Strategic Investment and the CBOE web site (www.cboe.com), which has information on LEAPS, including symbols and strategy discussions.