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Contingent obligation : The writer if any option contract is said to assume a contingent obligation,
meaning that he may or may not be asked to fulfill this obligation. This means that for the writer of an
equity call option there is a certain amount of uncertainty as to whether or not the obligation will have to
be met. There are, however, instances when an investor can determine that an assignment is very likely
or very unlikely.
Covered call : The writer of an equity call option assumes the obligation to sell 100 shares of the
underlying stock at a given price. If the writer of this option owns 100 shares of stock she is said to be
covered, as she can fully meet her obligation with the shares already owned. There is no margin
required when selling covered calls, i.e., the investor does not have to post any additional cash or
securities other than the stock underlying the short call options. A call writer who has written calls is
said to have a short position in these options. A call writer who does not own the underlying stock is
said to be writing uncovered (or naked) calls; this course does not cover uncovered call strategies.
Because all options have a finite life (i.e., their expiration dates are known), writers of covered calls will
either have to do something with their position before option expiration, or do nothing and live with
the consequences. If an investor has written calls and decides to do nothing, that is she will maintain
the short option position until expiration, she will either see the options expire worthless (when they are
out-of-the-money at expiration), in which case her potential obligation to to sell her shares will be
terminated, or, she will be assigned (if the options are in-the-money at expiration) and forced to sell
shares of the underlying stock.
If the investor decides to do something, before expiration she could buy back the calls she had
previously sold and by doing so terminate her potential obligation. If an investor buys back (or covers)
options previously written, she may be doing so at a profit or at a loss. For example, if an investor sold
some March 55 calls at $2.50 and repurchases them at $4.00, she would have a $1.50 loss per share,
or $150 per option contract. The price of the calls on the date they are repurchased will be a function of
the stocks price, the time left until expiration and other pricing variables. Roll your mouse over here to
view additional information on fees that may impact profitability that are not included in this example.
calls initial sale. He would then be in a position to sell another series of call options (for example the
April 30 calls) if he is still willing to sell his XYZ shares.
Finally, XYZ could fall in price below $28 over the coming two months. In this case the investors
accrued but unrealized profit on his XYZ would be reduced by the amount of the stocks decline. This
loss, however, would be partially offset by the $1.20 gain the investor realizes on the expiring out-ofthe-money call options.
Advantages of writing the XYZ February 30 calls at $1.20:
$1.20 per share profit will be realized if XYZ is unchanged over the next 55 days
If XYZ retreats, the calls offer partial downside protection, reducing the losses on the stock by $1.20
This strategy helps an investor stick with a set target price for selling the underlying shares.
Some investors may find that writing covered calls on stocks they own helps them with trading discipline
and forces them not to constantly change their target prices.
Disadvantages of writing the XYZ February 30 calls at $1.20:
Downside protection is limited to $1.20:
Investor may suffer an opportunity loss if XYZ rallies substantially above $30.
If the investors opinion on the underlying stock changes, exiting the covered write prior to expiration is
more complex than simply selling the shares, as the written options must also be repurchased
(covered).
doing so at a profit or at a loss. For the covered writer, it is impossible to tell if there will be a cost
associated with changing his mind.
So an investor who is considering writing covered calls as an alternative to placing an open sell order
for a stock held must weigh the following: receiving the options premium which will lead to
out-performance if the stock does not rise to the target price versus the higher probability of selling the
stock through an open order and the unknown cost of changing ones mind sometime in the future.
Yes. Assuming that this investor has the cash necessary to purchase the underlying shares,
waiting until tomorrow to exercise means postponing the purchase by one day. This means that
the cash can be retained and earn interest for an additional day. Of course, tomorrow the same
analysis can be made again and the purchase deferred another day to earn another days worth
of interest. The option holder has one very good reason to postpone exercising his calls: the
longer he waits, the longer his cash earns interest. Therefore, early exercise/assignment of calls
is relatively rare as there is no economic justification in spending money today when it can be
spent later.
There is, however, one exception to this, and that is when the underlying stock is about to go
ex-dividend. The question facing the call holder is: do I wait until immediately prior to expiration
and keep earning interest on my cash, or do I exercise on the day before the stock goes
ex-dividend, spend the cash early but collect the dividend? When equity calls are exercised early
it is in most instances for a dividend. Call writers should therefore be aware that the risk of early
assignment is at its highest immediately prior to the underlying stockss ex-dividend date.
But is being assigned early a negative event? The writer of a covered call knows that at best she
will sell her stock for the options exercise price. Being assigned early simply means selling the
underlying stock earlier rather than later, and at the same price. Most investors would prefer to
get paid today rather than tomorrow, and early assignment may be viewed as a positive.
If the starting point of the covered call discussion in the previous section was an investor with an existing
long stock position looking to cash-out by selling it at a target price, the starting point of this buy/write
discussion is an investor looking to invest cash instead. Here is what we mean: the buy/write is the new
purchase of underlying shares, and the simultaneous writing of covered call options. For example, an
investor could purchase 300 shares of XYZ at $62 and simultaneously write 3 of the June 65 calls at
$2.30 per contract. At most brokerage firms, both the purchase of the stock and the sale of the calls
can be entered as one order. Roll your mouse over here for more information on entering buy/write
orders.
Net Debits/Credits
Calculating the if-called return : The if-called return answers the question:
What will the strategys return be if the underlying stock rises above the options
exercise price, the calls are assigned and the stock sold at the options strike
price? The if-called return also represents the strategys best-case scenario,
the maximum return that can be realized. In dollar terms, the most that a
buy/write can earn is the appreciation of the stock from its purchase price to the
options exercise price (assuming that the calls written were out-of-the-money)
plus the option premium obtained in initiating the strategy. Continuing with the
same example used in calculating the static return, if XYZ is purchased at $57
and the August 60 calls written for $1.70, the stocks potential appreciation is $3
(from a purchase price of $57 to the options exercise price of 60) and the
options premium remains $1.70. The if-called return is then:
($3 + $1.70) / ($57 - $1.70) = 8.5%
Once again, it is customary to annualize this return, with the same formula used with the static return:
(8.5% X 365) / 70 = 44.3% annualized
As with the static return any dividends that accrue to the investor during the lifetime of the option should
be added to the investors profit. Roll your mouse over here for clarification.
A note of caution: some buy/writes will post eye-popping if-called returns. Investors must remember
two facts when looking at these returns: 1) the if-called return will only be earned if the underlying stock
rises above the options exercise price by the expiration date. This may represent a substantial rise in a
short period of time. And 2) an investor may not be able to realize the annualized returns based on
relatively short periods of time (such as 70 days in our scenario above) on a consistent basis. If the
buy/write in our example does earn its 44.3% annualized rate of return, there is no guarantee that in 70
days another comparable buy/write with a comparable rate of return will be available.
Stock Outlook
A buy/write is most appropriately defined as a neutral to moderately bullish investment strategy. This
means it will perform best using stocks that are expected to remain unchanged (neutral) or rise slightly
(moderately bullish). If a stock is expected to rise substantially a more bullish strategy may be in
order, although the buy/write will remain profitable if the underlying stock rallies strongly.
Comparing Different Buy/Writes for a Specific Stock
An investor has decided to initiate a buy/write on XYZ stock, currently trading at $125. She is
considering writing either the March 130 calls at $2, or the March 135 calls at $0.90. March options
expire in 60 days. She calculates the following annualized static and if-called returns for these two
options:
130 Calls 135 Calls
Static Return
9.9%
4.4%
If-Called Return
34.6%
53.4%
She notes that the 130 calls offer the higher static return and the 135 calls the higher if-called return. Is
one buy/write better than the other?
No. And herein lies one of the decisions every investor who initiates a buy/write must make: which strike
price should be chosen. A few points to keep in mind when deciding between various strike prices:
1. There is a greater probability of earning the static return than of earning the if-called return, since
the former only requires the underlying stock to remain unchanged, whereas the latter needs the
stock to rise to the options exercise price.
2. When comparing two options, the at-the-money (or the one closest to being at-the-money) will
have a higher static return, the out-of-the-money the higher if-called return.
3. The further a call is out-of-the-money, the greater the proportion of the potential return that
comes from stock appreciation, and the more the position starts to look like a straight stock
position.
There is unfortunately no best option that can be written, just choices between higher static and higher
if-called returns.
5.1%
21.2%
ZYX
7.4%
29.9%
both rates of return are higher for ZYX: the options premiums are higher,
indicating that the market is pricing these with a higher volatility estimate. In other words, the options on
ZYX are relatively higher because the market views ZYX as a more volatile, and therefore more risky,
stock. The covered write on ZYX is not better than the one on XYZ it simply offers a different risk
profile: higher potential return for taking on a higher level of risk. As a rule of thumb, abnormally high
rates of return generally come with higher degrees of risk.
Whenever investors find buy/writes with abnormally high rates of return they must realize that these
come at the cost of assuming a higher degree of risk.
Buy/Writes: Possible Outcomes at Expiration
If an investor has initiated a buy/write and takes no action prior to option expiration, there are only two
possible outcomes: the calls will either expire worthless, or the investor will be assigned and the
underlying stock sold at the options expiration price. (In the next section we will explore possible
actions to be taken prior to expiration).
Stock above options exercise price : If on expiration Friday the stock closes above the options
exercise price, it is more than likely that the options will be assigned and the investor who initiated the
buy/write will be forced to sell the underlying shares at the options strike price. The strategy will then
have earned its if-called return, the highest return it can generate.
Stock below the options exercise price : If on expiration Friday the stock is below the options
exercise price, the options will expire worthless and the writers obligation will be terminated. On the
Monday following expiration the investor will then have the opportunity to write another series of call
options. For example if the June options ceased trading on Friday the 18th, on Monday the 21st an
investor could write July or August options if she wanted to continue with the buy/write strategy. If the
underlying stock is unchanged or close to unchanged, calls with the same strike price as the June
options can probably be written. If the stock is down by more than a few dollars, the investor who
wants to continue writing covered calls may have to select a lower strike price than that of the June
options, a situation that could eventually produce a loss.
For example assume the stock was originally purchased at $43, and the June 45 calls sold for $1. If at
the June expiration the stock is trading down at $38 the June calls would expire with no value. On
Monday after expiration July 40 calls could be sold for $1. Since the investors initial investment was
$42 ($43 initially paid for the stock less the $1 premium received from the sale of the June calls), writing
the July 40 calls reduces this by another $1 to $41. If the stock is above $40 at July expiration and the
investor is assigned on the short July 40 calls, the net loss on the strategy would be $1 per share since
a total of $41 was invested but only $40 generated on the sale of the stock from the assignment. Some
investors may not want to write the 40 calls since they are locking in a loss, others may be willing to
do so since absorbing losses is part of investing.
If an investor enters into a covered write or a buy/write and does not take any follow up action, either
the written calls will expire worthless or they will be assigned or assignment can be expected and the
underlying stock sold. In certain circumstances doing nothing may be the preferred outcome; at other
times follow-up action may be appropriate given an investors outlook for the underlying stock. This
section looks at the most often used managing strategies: rolling out, and rolling up and out.
Rolling Out
Assume an investor is long shares of XYZ against which he has sold some
February 50 calls. It is now the Monday before expiration, XYZ is trading
at $52.60 and our investor knows that if he does nothing over the next 5
trading days and the price of XYZ remains above $50 he will be assigned
on his short calls and forced to sell his shares at $50.
Sometime ago, an investor initiated a covered write on XYZ, writing the January 55 calls. It
is now one week before January option expiration and XYZ has risen to $56.75. The
investor knows that doing nothing will most probably result in assignment and the sale of her
XYZ stock at $55 per share. She has considered rolling her short January 55 calls to the
February 55s but her outlook on XYZ is quite bullish over the short term and she is
considering rolling her option position up (to a higher strike price) and out (to a further
expiration date). Selected option prices on XYZ are given:
January 55 calls: $2.00 - $2.20
February 60 calls: $1.50 - $1.70
March 60 calls: $2.60 - $2.80
She considers the following two rolls: first, rolling up and out to the February 60 calls. She likes the fact
that this roll only extends the strategy for one month, but she realizes that to do so will require her to
put up additional capital as the roll can only be done for a $0.70 debit (buy the January 55s at $2.20
and sell the February 60s at $1.50). The second possibility is to roll up and out to the March 60s
instead of the February 60s. This roll can be executed for a $0.40 credit (buy the January 55s at $2.20,
sell the March 60s at $2.60), a net advantage, but it also requires her to commit herself to this new
position for an additional two months. How to decide?
There is obviously no one correct answer. This investor should weight the following: her comfort level in
holding XYZ an additional month or two; her willingness (or reluctance) to commit additional funds to this
position; her estimated likelihood that XYZ will rally to $60 or above over the next month or two
(remembering that if she does roll her position up and out, the strategy will then reach its highest
profitability if XYZ rallies above $60).
When to Roll Positions
The question arises as to how early, or how close to expiration investors should wait until they roll
covered calls (either out, or up and out). Two factors must be balanced: first, the longer an investor
waits, the more the time premium on the existing short option position decays and the cheaper it
becomes to cover those written calls; second, there is always the possibility of early assignment. If the
calls are assigned before they have been rolled, the whole discussion becomes moot, as the investor no
longer holds the stock and no longer has a short position in the expiring options.
Other Possible Rolls
The two rolling strategies described above, rolling out, and rolling up and out, are by far the most often
used managing strategies for covered writes. In specific instances investors may also want to
investigate the feasibility of the following strategies:
Rolling down : Moving from a higher to a lower strike price, keeping the same expiration date. For
example, rolling from the July 45 calls to the July 40 calls. Usually done when the underlying stock has
declined in price and a more defensive position is desired.
Rolling down and out : Moving from a higher to a lower strike price while pushing out the expiration
date. For example, rolling from the October 35 calls down to the December 30 calls. Once again,
usually done when the underlying has declined in price and a more defensive position is desired.
Rolling up : Increasing the strike price while maintaining the same expiration date. For example rolling
from the June 60 calls to the June 65 calls. This roll can only be done for a debit and is used when
investors have become more bullish about the underlying stock and are trying to capture more of its
upside.
See below to review the risks of early assignment. If no dividends come into play, the risk of early
assignment can be assumed to be relatively low and it is not uncommon for investors to wait until just a
few days prior to expiration before rolling their positions. But also remember that the risk of early
assignment increases the further in-the-money the calls move.
Early Assignment
All equity options are American-style options, which means that their holders
(buyers) have the right to exercise them on any business day, up to and
including expiration Friday. The flip side of this, is that the writer of an equity
option is at risk of being assigned early. Two questions need to be answered:
can the risks of early assignment be quantified, and is early assignment a
negative or a positive?
To quantify the risk of being assigned early on written calls, it is best to view this
question from the perspective of the option holder, the investor who purchased
call options. Assume an investor purchased some September 50 call options.
The underlying stock is now trading in the $54-$55 range. Should this investor
exercise his options early? The 50 calls give this investor the right to purchase
shares at $50. He could do so today, but he could also do so tomorrow. Is there
any advantage in exercising this right today? Not really. Is there any point in
waiting until tomorrow? Yes. Assuming that this investor has the cash necessary
to purchase the underlying shares, waiting until tomorrow to exercise means
postponing the purchase by one day. This means that the cash can be retained
and earn interest for an additional day. Of course, tomorrow the same analysis
can be made again and the purchase deferred another day to earn another
days worth of interest. The option holder has one very good reason to postpone
exercising his calls: the longer he waits, the longer his cash earns interest.
Therefore, early exercise/assignment of calls is relatively rare as there is no
economic justification in spending money today when it can be spent later.
There is, however, one exception to this, and that is when the underlying stock is
about to go ex-dividend. The question facing the call holder is: do I wait until
immediately prior to expiration and keep earning interest on my cash, or do I
exercise on the day before the stock goes ex-dividend, spend the cash early but
collect the dividend? When equity calls are exercised early it is in most instances
for a dividend. Call writers should therefore be aware that the risk of early
assignment is at its highest immediately prior to the underlying stockss
ex-dividend date.
But is being assigned early a negative event? The writer of a covered call knows
that at best she will sell her stock for the options exercise price. Being assigned
early simply means selling the underlying stock earlier rather than later, and at
the same price. Most investors would prefer to get paid today rather than
tomorrow, and early assignment may be viewed as a positive.
Rolling