Options Education: Covered Call Writing

Sex Sells… had to use Margo Robbie as the feature image or you probably wouldn’t have read this article.  Here she is talking dirty (at least to a finance dork):

August 9, 2016- I’m jumping ahead a little, but I want to get a series going about Options and other derivatives to bring readers up to speed.  I’ll come back and organize everything later in proper order, but since I just did a covered call today, why not talk about it.  Reading this article assumes you know the very basics of options.

The Covered Call

A covered call is a trade placed where you own the stock of a company and short/write calls against that stock.  Normally the purchase of a call option (going long) gives the buyer the right (not obligation) to purchase a specific stock, at a specific price (strike price), at a specified time (expiration date).  The opposite is true of shorting (writing) calls.  When shorting a call, the seller is obligated to sell a specific stock, at a specific price, at a specific time if the stock trades above the exercise price.

You can own stock of a company for years and later decide to short some calls against your position.  You can also do a trade called a buy/write where you are purchasing shares of the stock and simultaneously shorting a call against that stock.

Why would someone want to do a covered call?  It’s simple, income.  When you short a call against your position, you as the seller collect the option premium  as a credit to your account.  If the call that you are shorting is out of the money at the time of expiration, you keep your shares of stock and keep the option premium (no further trade is required since the option contract expires worthless).  So, shorting calls against your stock can generate a little extra income.

When is it appropriate to do a covered call? If you think the price of your stock is not really going to move up a lot, doing a covered call would be appropriate.  So you are neutral to moderately bullish.

Sounds simple right?  Not really.  You see the thing about covered calls, is that the strategy limits your upside potential up to the strike price of the option.  Sure you can collect a little premium and generate some income against your stock, but what if the company has a sudden spike in the share price.  You could be missing out on that upside.  So from that perspective, while a covered call is considered conservative, it is not necessarily the most profitable option strategy.

A real world example: So for about the last week, I’ve been waiting to place this trade and thinking about the timing for a while.  The trade? I have owned shares in eBay (EBAY) for a long time now and have been contemplating selling EBAY ever since the spinoff of PayPal (PYPL) about a year ago.  Why? Prior to the split, PayPal was the real growth story in eBay’s earnings reports.  The auction portion of the business wasn’t the shining star it used to be.  So after the split, I said to myself I’ll give it a little time and see how things go.  Well, here we are about 1 year later.  eBay is not only near a 52 week high, but at a high for a little over the last decade after a spike from a decent earnings reports.

Since I’ve been thinking about selling eBay for a while, I figured I’d let the market determine if I sell or not. So today (8/5/2016) I did a covered call by shorting the Sept 16 32 calls against my position in eBay at $0.63 a contract.  At the time of the trade, eBay was trading at $31.41.  What does that mean.  Sept 16 is the expiration date (Friday, September 16- which is 42 days away), 32 is the strike price for me having to sell eBay.  In exchange for my willingness to potentially part with my shares of eBay, I collect a premium of $0.63.  So come September 16th, if eBay closes below $32, I keep my shares of eBay don’t forget I also collected $0.63 in premiums.  If eBay trades at 32 or above come September 16th, my shares of eBay are called away from me.  I sell my shares of eBay at $32 per share and keep the $0.63 premium.

If we look at the return for the 42 day period by doing the covered call, I basically get a 2% total return based on the price of eBay at the time of the trade (0.63/31.41).  Not bad considering this is for a 42 day period.

Lets look at a few possible outcomes from the trade as far a best case/worst case scenario/break-even.

Graphically plotted out, all covered call trades look the same.  For this EBAY trade, here it is:

How did I arrive at the Sept 16th 32 calls?  When you look at the number of possible contract I could sell, why did I go with that particular option.  First of all the strike price of 32.  I wanted something just out of the money to give a little wiggle room for the price of eBay to go up.  I don’t need to sell eBay for any financial reason, I just think a lot of positive news is priced in and I’m not opposed to trying to make a little extra cash.  I guess you could say, I’m impartial to selling eBay.  So, the 32 strike price gives me enough of a premium to collect, but also about 2% more upside on the current price of eBay.

Next we have decide which weekly, monthly, or LEAP contract to short (LEAP=options expiring over 1 year).  I can pretty much scratch any August contracts because the risk/reward trade off is not there.  I don’t collect enough premium (in my opinion) to justify the risk of eBay having a sudden run up.  Looking into October, eBay’s next earnings report is October 19th, so I can’t again justify the premium collected from shorting the October 21 call options (if eBay is to have another spike in its price, it is most likely to occur after reporting earnings).  I don’t have any interest in the LEAPS, too many possible outcomes can happen.  So looking at September, I see the September 16th contract trading at $0.63 and the September 23rd trading at $0.69.  September seems good to me, because it avoids the earnings report from October and really only macroeconomic factors that would drive the markets in general, should be what impacts eBay.  There could always be some surprise announcement from the company, but I place the odds of this happening in the timeframe I’m looking to be a low chance of happening. So it boils down to the 16th or the 23rd.  I settled on the September 16th contract primarily because the extra $0.06 in premium collect from the 23rd weekly contract isn’t worth it to me.  Sure it’s an extra 20bps (basis points) for the week, but not enough to justify to me.  Plus I can always later short another October weekly contract (preferably prior to the earnings report).  So, that’s the logic on how I settled on the September 16th contract with the 32 strike price.  Simply a risk/return perspective.

Changing Your Mind: Let’s say eBay suddenly drops to $30 and the value of the option I’m short were to drop to $0.10.  I could simple cover my option (buy to close) and pocket the profit of  $0.53.

On the other hand, let’s say eBay rises to $32.50 and I change my mind and wish to hold onto the shares.  I could simply cover my call option by purchasing them at a higher (market) price.  This creates a short term capital loss on the option that I can use to offset against any capital gains for the year, or against up to $3000 ordinary income.

Taxation: If the call option expires worthless, the $0.63 premium is taxed as short term capital gains.  If I’m wrong on this trade, the gain on the sale of eBay will be taxed at long term capital gains since I’ve held the shares well over a year, and also I owe short term capital gains on the $0.63 call premium.

However, the interesting thing because of my income situation and our lovely tax codes, either outcome I won’t owe any long term capital gains on the sale of eBay because my ordinary income for the year is limited and the short term capital gains rate for me is max 15% on the option premium collected.  A nice benefit of not having earned income, but also the government seeing me as broke since I don’t have working income coming in the door.  It’s actually ironic that a guy like me can see $100,000+ in appreciation from his investments and because of buy and hold investing and tax deferred accounts, pay practically nothing in taxes (don’t worry, I paid more than my fair share in my working years).

Conclusion: This is just a short primer for covered call writing, as I could probably talk about this particular type of trade and all details for about 2 hours.  The main things to be aware of with covered calls is that you can generate income from your stock holdings.  However, it is not without risk.  The worst possible outcome from a covered call is having the underlying stock suddenly spike up in price, meanwhile you’ve only collected a paltry 1-2% worth of call premiums.  You always have to weigh the risk/return.  Also, covered call writing is not for someone who is not really wanting to have their stock called away from them.

I will update this post if I close out the trade or when the option expires and let you know ultimately what happens.

Sound off below with any questions, comments, or concerns.

***Update 9/16/2016***

As promised (and since I like to use real world examples on this site and not just talk theory) here are the updates of the results from this trade.

First of all Ebay settled at $31.77 per share at the market close on 9/16/2016.  This means my short calls with an exercise price of $32 expired worthless to whoever was the buyer of my short.  For me that means I collected the full call option premium of $0.63 per share and still have all of my shares of Ebay.  I didn’t have to close out or cover my position at all (saves on trading cost).

Here is a chart I prepared of the results comparing my Ebay Covered Call trade vs Just Owning Ebay vs S&P500 performance for the same time frame:

So let’s talk money and returns: In this instance the covered call trade resulted in a total return of 3.15% for the 42 day period.  Compare that to holding just a position in Ebay with a return of 1.15%.  The difference in return is purely from collecting and keeping the full option premium for a net difference of 2%.  Compare both of those results to the S&P500 loss of -2.002% (if you haven’t noticed the markets have been all over the place thanks to the Fed and interest rate fears).  So my covered call trade beat the S&P500 by 5.15% during those 42 days.  Not bad at all.  You can look at the Ebay profit chart above (first table) to how things would have played out had Ebay gone over $32.

This trade worked out great.  I got return on the stock position, income from the short call, and kept my stock position.

So what’s next? I’m already planning my next trade.  Something similar but using the October 14th calls, since that is before the earnings report date.  Not sure if I’ll go with the 32 again or 32.50.

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