Optin Box close
Welcome to the Options University Blog

This is no ordinary ebook. Options 101 just hit the bookstore shelves all over the country. It's available at Amazon.com and BarnesandNoble.com and we've been told it's the 'best options book on the market today'.

Because we feel that a proper foundation in options is critical to your success,
We'd Like To Offer You
3 FREE Chapters
of Our NEW Book
Options 101:
From Theory to Application
by Options Expert Bill Johnson
To get your 3 FREE chapters, simply enter your name and email address below, and we'll send these to you right away
(You'll have them in your email inbox instantly!).
"It's fun for me to spend time with people that are really bright and passionate about something that I love as well. Options University has done a wonderful job of getting their message across in an easy to understand way. I hope this is the first of many..."

Tom Sosnoff
thinkorswim, inc.
Name:
E-mail Address:

Nov

14

Hedging with Covered Call Options

Filed Under Beginner Options Trading 

Hedging with Covered Calls
Many investors are attracted to covered calls because of the immediate cash that can be generated into the account. Because of this, they tend to write the “full amount” of contracts against their shares. For example, if they own 500 shares, they will write five contracts. While this does maximize the amount of cash generated for any given strike (and create the largest downside hedge), it does have its drawbacks. That is, if the stock makes a sudden move upwards, then your gains are capped and the covered call writer often has regrets about having written the calls in the first place. One way to combat this potential regret is to not write the full amount of contracts against your shares. For example, if you own 500 shares, you may consider writing something less than five contracts – anything from one to four contracts. While you will not bring in as much money, you will keep some of the upside open in the event the stock does spike up. By writing less than five contracts, you are hedging your bet between writing no calls and writing the full amount. It’s just something to consider, especially in cases where you believe there is potential for the stock to break out of a range and continue higher. It’s very tempting to want to write calls but it may come with large regrets later. Hedging the position by writing fewer calls can be a simple solution. How does this affect the position? Take a look at Figure 7-6. The shaded line is the profit and loss curve for an investor who buys 300 shares of AGIX and writes three of the $20 calls for $4.40. The bold line is the curve for the investor who buys 300 shares but only writes two of the $20 calls for $4.40:
 
Figure 7-6: Long 300 Shares AGIX Plus Two Short $20 Calls (Bold Line)
 

Figure 7-6

Notice that the profit and loss diagram for the bold line does not flatten out after the $20 stock price. The reason is that this investor purchased 300 shares but only wrote two calls so he is only obligated to sell 200 of those shares. This investor will always have 100 shares free and clear to participate in upside gains above $20.
 
The tradeoff between writing two calls instead of three is that you don’t get as much of a downside hedge since you receive less money. Figure 7-6 shows that the bold line doesn’t have as much downside protection. It is therefore riskier and that’s why it comes with a bigger reward.
 
This is a good example showing once again that all option strategies are about tradeoffs. Any time you buy or sell an option to create some type of advantage there must be a negative aspect somewhere. Do not enter into any strategy until you clearly understand what the benefits and drawbacks are. It is impossible to find a strategy that only offers benefits. It is also impossible to find a strategy that beats all other strategy for all stock prices. It is up to the investor to decide which benefits are worth having in exchange for the drawbacks.
 
 
Will I Get Assigned Early?
If you write a covered call, don’t expect to get assigned or “called out” early even if the stock’s price is well above the strike price. In Chapter Four, we showed that it is never optimal to exercise a call option early with the exception of collecting a dividend. With a covered call, you have a short call position; another trader somewhere has the long side of that trade. If it is not in his best interest to exercise that call early then you shouldn’t expect to get assigned early.
 
Now that you have a better understanding of covered calls, we can revisit that topic and gain a new appreciation why it is not in the best interest of the long call holder to exercise early. Assume that you buy stock for $100 and write a one-year, $100 call for $10. That means that the most you could make from this trade is $10 if the stock’s price is above $100 in one year, which would net you a 10% gain (actually, your gain would be higher than 10% since you’re collecting the $10 up front but we’re just trying to make the example simple to follow). But if you hold the position for less than a year, your gains are magnified. For example, if you are assigned after six months, then your annualized rate of return jumps to 20%. If you are assigned after three months, your annualized return is 40% and so on. This shows that the shorter time frame you hold the covered call, the better off you are since you were paid $10 to hold the stock for a full year but ended up holding it for less time. The better off you are then the worse off is the long call holder. Since the long call holder controls the right to buy stock (he controls the exercise instructions), he will not exercise early. This shows that you should not enter into a covered call with the intent of being called out early. Also remember that it is not your decision as to when to end the contract; that’s up to the long call holder.
 
As an example, I remember a client who once wrote covered calls with nearly a year until expiration. He collected a healthy premium but the stock quickly rose above the strike price, which means his account wasn’t reflecting any of the daily gains in the stock. He called in one day and said, “I think I’d like to be called out on this stock now.” After I explained that it was only the long position that could submit exercise instructions, he then realized the tradeoff of writing longer-term calls. While he did get a much higher premium for writing a longer-term contract, his money was tied up in the stock for that year. The investor could buy the calls back but then that cuts into the anticipated gains. So if you are writing longer-term contracts, you should not expect to get assigned until expiration. Also, you should not expect to get assigned even if a dividend is about to be paid. The reason is that upon exercising a call, the long position sacrifices the call (he cannot sell it) so he loses all of the time value in the call. If you are writing longer-term calls, the value of the time premium is probably far greater than the dividend.
 
However, anything is possible in the markets. We have seen people get assigned (called out) early on covered call positions. If this happens it is only an advantage to the call writer. Remember, if you get assigned early you just receive your money earlier rather than later. It’s a huge advantage to you. But again, this is why you shouldn’t expect it to happen.
 
 
How Will I Know If I’m Assigned (Called Out of a stock)?
If you are ever assigned on a call, you will be notified by your broker the following business day.
 
But be careful at expiration and do not assume that you will not be assigned just because the stock closed below the strike price on Friday. The reason is that many brokers allow you to exercise the call after the closing bell. It is possible that after-hours news could propel the stock to new higher prices and you could get the assignment notice on Monday.
 
Using our AGIX example, assume you have purchased 100 shares and sold one $20 call. It is now expiration day and the stock is trading below the $20 strike, say $19. Because its price is below the strike, you decide to not pay the commission to close the call and just let it expire worthless. However, after the close, a news story hits stating that the company will be bought out at $30 per share. Upon hearing this news, the long call holders who thought their $20 calls expired worthless could potentially make $10 just by exercising the call. All they have to do is call their broker and exercise the call option.
 
They will pay $20 but receive stock worth $30, which they can immediately sell for a $10 gain rather than the 100% loss they took by letting the option expire. Even if the call owners are afraid the stock might fall on Monday, they could short shares in the after-hours market for $30 per share and then cover it for $20 by exercising the option. That’s the risk-free route. The point is that there will be big demands to exercise the call and you can bet that assignment notices are likely to follow on Monday. If you do not have an assignment notice on Monday morning following expiration (assuming that’s not a holiday), you can be sure that you were not assigned on the call.

Share This

Comments

Leave a Reply

You must be logged in to post a comment.

Close
E-mail It