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Covered Calls: Buyers Have Rights, Sellers Have Obligations

05/18/2020 10:14 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman explains the important distinction and reasons options are bought and sold as it relates to covered call writing.

Covered call writers get paid cash when selling call options. Call buyers pay cash to own the options.

Here, we highlight the reasons options are bought and sold as it relates to covered call writing. We will use a real-life example with CarMax, Inc. (KMX) from 2019.

KMX option chain on Oct. 30, 2019 with KMX priced at $95.35

KMX 

KMX calculations with The Ellman Calculator

Return of Option Calculator 

When the trade is executed, an initial one-month time-value return of 2.5% is generated with an additional 0.7% of upside potential for a possible 3.2% one-month return. Now, let’s look at this trade from a buyer’s and seller’s perspectives.

Option buyers have rights

The option buyer is now controlling 100 shares of KMX per-contract until the Nov. 29, 2019 expiration at a cost of $240. The cost of buying 100 shares would be $9,535. The buyer has the right, but not the obligation, to buy 100 shares of KMX (per-contract) at $96. This makes the breakeven at $98.40. ($96.00 + $2.40).
The buyer can:

  • Sell the option
  • Exercise the option (buy shares), or
  • Allow the option to expire worthless

Approximately 70% of options are closed, 20% expire worthless and 10% are exercised.

Option sellers have obligations

As option sellers, we are required to provide shares to the option buyers (if they choose to exercise the options) at the strike price and by the expiration. By first buying the shares, we are in a “covered” or protected position; we know our cost-basis. By undertaking this obligation, we are paid a cash premium. The seller can:

  • Buy back (close) the short call (buy-to-close) and end the contract obligation, or
  • Allow the contract to reach expiration to expire worthless (if strike ends out-of-the-money) or result in exercise (if the strike expires in-the-money)

Discussion

Option buyers pay for the right to control shares of stock or exchange traded funds or futures contracts at a relatively low cost. If they are directionally correct, there is an opportunity to generate impressive returns on the capital investment. Generally, this is a more aggressive approach to option trading than covered call writing.

Option sellers are paid to make shares available to call option buyers. We select the price we are willing to sell our shares for and the length of the contract duration. Generally, this is a more conservative approach to option trading.

It can get complex, but generally, options buyers have limited risk and pay a premium for it; options sellers have (theoretically) unlimited risk and look to collect a premium for taking it on.

Use the multiple tab of the Ellman Calculator to calculate initial option returns (ROO), upside potential (for out-of-the-money strikes) and downside protection (for in-the-money strikes). The breakeven price point is also calculated. For more information on the PCP strategy and put-selling trade management click here and here

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