Reinforcing key points
And, again, John must be prepared to sell the stock if it is called away.
Investors have a range of possible objectives. “Income” and “growth” are two of the more general and well known objectives. The covered call strategy falls in the income category of investments, because the call premium received is often treated as income. Nevertheless, there are a number of specific objectives that must be identified before engaging in the covered call strategy such as the willingness to sell the underlying stock, the desire for option premium income or capital gain income and the amount of time available.
The first and most obvious aspect of the covered call strategy that investors must address up front is the obligation to sell stock. Remember, a covered call position is an obligation to sell the underlying shares at the strike price of the call. Therefore, sellers of covered calls must decide if they intend to sell the stock or not.
“I am willing to sell the stock” can include two possibilities - “I definitely want to sell the stock,” and “I am willing to hold the stock or sell it.” There is a third possibility - “I definitely do not want to sell the stock.” Even though a seller of covered calls must sell the stock if an assignment notice is received, and even though the seller has no control over being assigned, it is still viable to sell covered calls when the goal is to keep the stock. One must, however, choose a call with a low probability of being assigned and one must have a plan to act if the chances of the call being assigned increase to an unacceptable level.
The second aspect of the covered call strategy is that it offers two sources of potential profit or loss. The first source is from the call premium received, and the second source is from potential stock price appreciation. Investors, therefore, must decide how much they hope to get from each potential source. If an investor forecasts that a stock will “trade sideways,” then it is logical to want more profit from the covered call than from the expected stock price appreciation. However, if a stock price rise is expected, then it is logical to hope for relatively more profit from stock price appreciation and relatively less from the covered call.
Probability of being assigned
Due to the risk of a stock price decline and there being no assurance that a covered call will result in the sale of the underlying stock, investors must incorporate probabilities into the decision of which covered call to sell. Probabilities are not a guarantee of success, but if the goal is to sell the underlying stock, then choosing a covered call with a higher probability of being assigned makes sense. Conversely, if the goal is to not sell the underlying stock, then choosing a covered call with a lower probability of being assigned makes sense.
Mathematical models of stock price behavior predict that stock prices – most of the time – will trade in a narrow range near the current stock price. Therefore, with regard to mathematical probabilities, calls with lower strike prices have higher probabilities of being assigned. At-the-money calls have approximately a 50% probability of being assigned, and calls with strike prices above the current stock price have a lower probability of being assigned.
Let’s look at three examples. Generally speaking, if stock XYZ is currently trading at a price of $50 per share:
|XYZ 45 Call||Would have a “high probability” of being assigned at expiration.
In this case the price of XYZ would have to decline more than 10% prior to expiration – from $50 per share to below $45 – in order for this call to expire without being assigned.
|XYZ 50 Call||Would have approximately a 50% chance of being assigned.
Mathematically, with the stock price at $50, there is a 50% chance the stock price would be above $50 at expiration and the call will be assigned (and the stock sold) and a 50% chance the stock price would be below $50 and the call would expire worthless.
|XYZ 55 Call||Would have a “low probability” of being assigned
The price of XYZ would have to rise more than 10% prior to expiration – from $50 per share to above $55 – in order for this call to be assigned.
Need for a 2-part forecast
As every investor knows, stock prices fluctuate over time. But as basic a concept as this is, investors who use covered calls need to include both of these elements – price and time – in their forecast when choosing a specific covered call.
For example, assume an investor believes that stock XYZ will rise in price from $44.00 per share to $54.00. Given this forecast, it is not logical to sell a 45-strike call for $3.00 per share, because selling such a call would result in a total sale price of the stock of $48.00 per share and a total profit on the covered strategy of $4.00 per share. The total sale price of the stock is calculated by adding the strike price of the call to the premium received, or 45.00 + 3.00 = 48.00. Any investor who forecasts a stock price rise of $10 per share and a $1,000 profit on 100 shares would not be attempting to maximize profits by choosing a strategy with a maximum profit of $4.00 per share.
Alternatively, if an investor believes that stock XYZ will rise in price from $44.00 per share to $48.00, then selling a 50-strike call for $1.00 per share is consistent with the forecast. Given the forecast of a $4.00 price rise, selling this 50-strike call would add $1.00 per share profit to the $4.00 stock profit if the call expired. The 50 Call in this example would also result in a total sale price of the stock of $51.00 per share and a profit of $7.00 per share if the stock price rose above $50. This is $3.00 per share higher than the forecast. The total sale price of $51.00 profit in this example is calculated by adding the strike price of the call to the premium received, or 50.00 + 1.00 = 51.00. An investor who forecasts a stock price rise of $4 per share and who sells a call with a strike price $6.00 above the current stock price is attempting to add profits above the forecast stock price rise.
Although it is highly unlikely that a forecast will be exactly correct, a specific forecast for stock price and time period will lead to the selection of a covered call that is consistent with the investor’s market view.
General comment on selecting a strike price
Choosing a strike price for a covered call is a subjective decision that every investor must make individually. There is no “right” strike price. However, there are some guidelines. In general, an investor should try to match three things.
- Consider his or her willingness (or lack thereof) to sell the stock.
- Make a 2-part forecast for the stock and time period as described above.
- Consider the probability that the call will be assigned.
After considering these three factors, the investor should pick the strike price that, in the investor’s opinion, comes closest to matching all three.
Selecting a strike price – if you want to sell the stock
Every investor at some point has a stock they want to sell, and there are many possible reasons that an investor might want to sell. However, covered calls can be used to target the goal of selling a stock only when there is “no urgency” to sell. Lack of urgency is necessary when using covered calls, because options have expiration dates which are inevitably at some point in the future. Also, covered calls involve the risk of a stock price decline, so there is no assurance that a covered call will be assigned and the stock will be sold. If an investor needs the full cash proceeds from the sale of the stock immediately, then the stock should be sold at the current market price.
If an investor definitely wants to sell the underlying stock, and is fully willing to assume the risk of not being assigned, then selling a call with a strike price below the current stock or very close to the current stock price is a logical choice, because these calls have relatively high probabilities of being assigned.
Selecting a strike price – if you are willing to hold or sell the stock
Almost every investor has in their portfolio at least one stock that is considered to be a “good long-term hold.” Perhaps the stock pays a “good and growing” dividend. Perhaps, the cost basis of the stock is very low and selling it would create a large tax liability. Whatever the reason, there is no desire to sell this stock. In fact, there is an emphatic desire to not sell the stock.
On the surface, selling a covered call against such a stock might seem contradictory to the desire to hold. Nevertheless, some investors sell covered calls against such stocks for the purpose of bringing in incremental income.
If an investor owns a stock they do not want to sell and chooses to sell covered calls, there are two prudent guidelines. First, the strike price of the call should be above the current price of the stock by a distance with which the investor is comfortable. Specifically, the investor’s forecast for this stock should be that the stock price will not rise above the strike price of the call. Second, given that no investor is infallible in making forecasts, there must be a plan to close the covered call, i.e., buy to close, if the stock price rises to the strike price of the covered call.
Despite these steps to avoid having a call be assigned, all covered call writers are giving up control and must accept the possibility that the call will be assigned. Although not “likely,” it is possible that a stock price can rise suddenly and sharply above the strike price of a covered call and that the call can be assigned. Investors who sell covered calls on stocks that they do not intend to sell are assuming the risk of such events.
General comment on selecting an expiration date
Every stock on which options are traded has at least four expiration months available for trading. There are the first two immediate months plus the next two months in the stock’s quarterly expiration cycle. For example, assume that today is June 1 and stock XYZ trades options on the March, June, September, and December cycle. Stock XYZ, therefore, will have June and July options, which are the first two immediate months, and September and December options, which are the next two months in the quarterly cycle.
In addition to these four expirations, over 650 stocks have two more long-term, or LEAPS®, expirations that expire in the next January that is more than 12 months away and the following January. Several stocks also have options with very short-term expirations known as Weeklys® options.
How does an investor pick an expiration date from this wide range of choices? The answer frequently comes down to “time.” Writing covered calls with short-term expirations tends to take a considerable amount of “time” to manage. While writing calls with six months or longer to expiration generally takes much less “time” to manage. Therefore, investors should consider their individual trading style and their ability to commit the necessary time to the tasks of picking stocks, following the market and writing covered calls.
Selecting an expiration date – I have a lot of time to trade
Short-term options (60 days or less to expiration) with strike prices close to the current stock price are often viewed as desirable options to sell, because these options tend to have the highest amount of time value per unit of time. As a result, they tend to have very attractive static and if-called rates of return.
However, writing covered calls every month or even every two months requires a considerable amount of time to follow the market, pick stocks, watch positions and make adjustments as necessary. As a result, selling short-term options tends to be suited to those investors with considerable time to devote to this activity.
Selecting an expiration date – I do not have much time to trade
Intermediate-term options – 90 days to six months – with strike prices at least 5% above the current stock price tend to bring adequate amounts of income in the form option premiums. And although the risks of declining stock prices and early assignment always exist, covered calls of this nature tend to require less time to monitor.
Selling intermediate-term options, therefore, tends to be suited to investors who are less inclined to follow every up and down and twist and turn in the market.
Investors have a number of potential objectives, and the covered call strategy fits mostly in the “income” category. Every call option has a mathematical probability of being assigned:
- Call options with strike prices below the current stock price have the highest probability of being assigned.
- Call options with strike prices equal to the current stock have a probability of approximately 50%.
- Calls with strike prices above the current stock price have the lowest probability of being assigned.
Investors who use covered calls should consider a 2-part forecast for the underlying stock before selecting a strike price or an expiration date for a covered call. The forecast should consider the:
- Size and direction of the stock price change, and
- The amount of time that the forecast move will take.
While no forecast will ever be exactly correct, a clear price and time forecast will lead to a covered call that is consistent with the investor’s forecast.
In choosing a strike price, investors should consider whether they:
- Intentionally hope to sell the stock,
- Are willing to hold or sell, or
- Do not wish to sell.
Matching this intention with the mathematical probability of being assigned will lead to a strike price.
In choosing an expiration date, investors should consider the amount of time they are willing and able to devote their covered call writing activity. When more time is available, there is a tendency to sell options with 60 days or less to expiration. Otherwise, selling calls with 90 days to six months or longer tend to be less demanding in terms of the time commitment.