In my most recent option class, I was asked to cover the topic of covered calls in greater detail than what is normally covered in the class presentation. As always, I pulled up an example thrown at me by my students and started studying the chart.
The ideal candidate for this strategy should be in a mildly bullish trend. If the stock were rallying, then it would not qualify for an ideal selection. However, selecting a candidate is only the first step in the strategy application.
The next step becomes an issue of whether to enter into the trade at the same time (buying the stock and selling the call) or in two parts. Below are the two scenarios spelled out:
- Scenario One: Buy the stock first and then sell the call when the time is right
- Scenario Two: Simultaneously do both, buying and selling
For simplicity's sake, I shall go over each one separately.
Scenario One
Buying the stock first and then selling the call when the time is right would be the very first choice, yet even within that choice, there are multiple choices, such as which strike price to sell for which month and also when is the most ideal time to do it. Let us address each one of these.
An unnamed stock at the time was trading at $18.05 and was approaching its resistance at $20. It was in a moderately bullish uptrend, yet it was not ripping to the up side; grinding up would be a more accurate description. The majority of the students in the class were willing to enter it right then and there, because it was in an uptrend. The aim was to buy it at $18.05 and then wait for the stock to go up to resistance, which once again, was on the chart around $20.00.
At that point, around $20.00, it was obvious to all present that selling the 20 call by pressing STO (Sell to Open) would have been the logical choice.
After answering the question of which strike price to sell, the issue became which month to sell. Due to the fact that we looked at this trade four days prior to March expiry, we could not simply select the front month because there was virtually no premium left in the March 20 call. The next months out were April and June. May options were not listed since only after March expiry will they be posted.
The choices involved are to sell the April 20 call for a premium of $0.11 with 31 days remaining, or the June 20 call for $0.29 with 94 days left. It is at this point that it became evident that selling them at the same time as buying a stock would be our second scenario, hence, the question became how to calculate how much the premium would be for those two calls, April 20 and June 20, if the underlying was at or around $20.00.
I took time to do the manual calculation for the class so they could grasp the math behind it. The component that I left out of the equation was the implied volatility. I solely focused only on two Greek components: The Delta and the Gamma.
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|pagebreak|Below is a snapshot of the TradeStation option chain, with the actual ticker blocked out. Observe the red ovals encapsulating the essentials.
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In order to present the info in an easier manner, I have pulled out some facts from Figure 1 into the charts below. They involve the cost of premium of the April 20 call at the Bid (0.11), its Delta (0.156), and Gamma (0.14). Out of these three given pieces of data, I have constructed what takes place as the underlying increases in value one point, from $18.05 to $19.05. Then also what takes place when the underlying increases another point from $19.05 to $20.05, which is exactly where our resistance is on the underlying.
For April:
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The same procedure is done for the June 20 call. Hence, when the price comes to 20.05 cents, the choices presented to us involve either the sale of the June 20 call for $1.03 plus or minus, or the sale of the April 20 call for approximately $0.55.
Looking at the money (premium), the June 20 call looks like the better choice, yet that is not how this trade should be approached. Looking at the time until expiry is where the answer lays. The June 20 call has 94 days, while the April has 31 days. Therefore, it makes more sense to sell the April for only $0.60, and then after the April expiry, to sell the May 20, and then finally to sell the June 20 call. Now let us move on to the second scenario.
Scenario Two
This scenario involves simultaneously buying the stock and selling the call. Keep in mind that if buying only 100 shares, only a single contract can be sold since each options contract represents 100 shares. This goes without saying, however, it is essential to reinforce the contract size just in case.
In order to do the simultaneous action, timing needs to be right. This will be addressed in greater detail in the next article.
Certainly, the scenarios presented here aren't the only ones available to the option trader. One alternative choice could be to ride the stock from 18 up to 20, which is both a major resistance as well as the target of the move, then exit the long stock by taking the $2 and then simply move on.
For some traders, that would be the ultimate choice, while others might choose to sell the 20 call and wait around for 31 days to keep the additional $0.55. In either case, the choices are there.
In conclusion, in this article I have focused on answering which strike price and month of a covered call to sell. The issue of selecting a candidate that is somewhat bullish to sideways was also addressed. Good trading, and until next time, watch your position sizing!
By Josip Causic, instructor, OnlineTradingAcademy.com
