Covered Call Proximity—Identifying the Best Choice

07/24/2015 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Michael Thomsett, of ThomsettOptions.com, highlights the importance of covered call proximity and while dollar values of longer-term options are higher, Michael also emphasizes that options traders may find that the annualized return for short-term options are much better.

Covered Call Proximity is the determining factor of the short call’s value. The closer the underlying  price is to the strike, the greater the option’s price response to the price movement in the stock. The farther the proximity, the less responsive premium levels will be. Those wanting to avoid or defer exercise may shy away from close-proximity positions or, worse yet, may select OTM positions expiring much later. Both of these decisions adversely affect outcome. You are likely to realize many more profits by focusing on close-proximity, soon-to-expire strikes.

The proximity, however, is only one of two issues. The other issue is time to expiration. In selling covered calls, you want to get the greatest dollar amount possible when you sell to open, so longer-term options are more attractive, at first glance, because time value is higher. But leaving the exposure for a longer period also increases risks. The solution normally is found in options expiring between one and two months. During this period, time decay accelerates more than at any other time.

Even though dollar values of longer-term options are higher, you will find that the annualized return for short-term options are much better. In other words, you will make more profit writing six 2-month options per year, than you will writing two 6-month options. To annualize, calculate the return (divide option premium by the strike). Then divide the return by the number of days between now and expiration. Finally, multiply by 365 to get the equivalent annualized return.

An equally troubling aspect to covered calls is the risk of loss. Because a covered call includes ownership of stock, a decline in stock value makes the option profitable but not the stock. If price declines below net value, you will have a net loss. The net value is the basis in the stock, reduced by the premium received for selling the call. For example, if you paid $52 per share for 100 shares and sold a call for a premium of 3 ($300), your net value is $49 per share. If the share price falls below this level, you have a net loss. In this situation, you can sell another call to make up the difference, but if the strike yields less than your net value, it creates a loss. You can also just wait out the price movement, hoping for the price to rebound. But these alternatives are not satisfactory.

As an alternative, consider other strategies. These include the variable ratio write, in which you sell more calls than you cover, using two strikes. One issue with this strategy is the collateral requirement for the uncovered options, equal to 100% of the strike value. For example, if you buy 300 shares at $52 per share and then sell two 52.50 and two 55 calls, you are out-of-the-money on all four options, which is desirable; but you also have to deposit additional collateral of $5,250 for the uncovered option. Another way to achieve the same market risk is with the uncovered call. You have to deposit collateral in this case, as well. But market risk is the same as covered call risks, with more flexibility. For example, if you sell an uncovered 50 put, you have to deposit collateral of $5,000 in your margin account. If the stock price falls below $50 per share, you can close the put or roll it forward. The big advantage in rolling is that you are not concerned with the strike because you will not have to worry about net loss on stock (as you do with the covered call).

Disadvantages to the uncovered put include no dividend and less cash outlay. For the covered call, you can open the stock position for 50% and leverage the other 50%; and there is no collateral requirement. The uncovered put demands more cash for collateral, in exchange for more flexibility.

For all of these strategies and alternatives, selection of the most advantageous proximity between strike and current price of the underlying is a key to managing risk. This, plus time to expiration, defines the difference between a successful risk management strategy and one heading for problems.

By Michael Thomsett of ThomsettOptions.com

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