Anyone tried selling deep ITM Leap covered calls?

[Don87109]

Quote from DeltaSpread:

What he said. Selling naked puts is always going to be the better choice in this scenario. And as long as you are selling the number of contracts that reflects the actual number of shares you had intended to and are capable of buying, you will be fine. It would be logistically no different than physically buying the shares and selling the calls.

I beg to differ a little bit. Many brokers do not pay decent interest on cash. Therefore many times a covered call is preferable to a NP.

For example, IB does not pay interest on the first $10k of cash. Clearly if your account is small like this a CC is better.

Another example, OE only pays very low interest on cash (under 2%). In their IRA's they insist on liquidating the cash from the good interest sweep account for any cash secured NP's. Again CC's make more sense in that case.

I have heard that TOS has similar problems to OE in this regard.

Best bet is to know your broker policies and do the math to decide which is best (NP or CC).

Don

 

[daddy'sboy]

Quote from Eliot Hosewater:

How do you get that? Here is the way I figure it.

His cost for the stock is 15.50 - 8.80 = 6.70. Assuming the call is assigned he will sell the stock for 7.50. So his profit will be .80 on a cost of 6.70, or 11.9%.

I'm trying to see what PowerOpt calculates, but I'm getting database error messages there.

You're right, I forgot to deduct the premium for the short sale .

 

[Eliot Hosewater]

Quote from Don87109:

I beg to differ a little bit. Many brokers do not pay decent interest on cash. Therefore many times a covered call is preferable to a NP.

For example, IB does not pay interest on the first $10k of cash. Clearly if your account is small like this a CC is better.

Another example, OE only pays very low interest on cash (under 2%). In their IRA's they insist on liquidating the cash from the good interest sweep account for any cash secured NP's. Again CC's make more sense in that case.

I have heard that TOS has similar problems to OE in this regard.

Best bet is to know your broker policies and do the math to decide which is best (NP or CC).

Don

This is drifting off topic a bit, but are there any brokers who pay interest on cash received from shorting a stock? I was short 100 shares of GOOG last month and when the end of the month came around I didn't see any interest deposited for the $40+K. It turns out that they don't pay. I guess they keep it for themselves. The broker is Fidelity, but from what I hear it is common practice for most brokers. I don't have mych experience with shorting stock.

 

[Don87109]

Quote from Eliot Hosewater:

This is drifting off topic a bit, but are there any brokers who pay interest on cash received from shorting a stock? I was short 100 shares of GOOG last month and when the end of the month came around I didn't see any interest deposited for the $40+K. It turns out that they don't pay. I guess they keep it for themselves. The broker is Fidelity, but from what I hear it is common practice for most brokers. I don't have mych experience with shorting stock.

I don't know of any brokers who pay interest on short stock. Although I think IB does pay some interest on the amount of the short balance over a certain threshold (I think over $100k).

I have heard that shorting futures is one solution to overcome this limitation. However, I am not sure if it's because futures pricing includes an interest component or if it's because brokers pay interest on short futures credit. Maybe someone else can clarify.

Incidentally, some stocks have futures contracts (SSF) but I don't know if Google is one of them.

Don

 

[Eliot Hosewater]

Quote from FullyArticulate:

Your math is right, except you have to account for the interest. At 5.3% (roughly LIBOR), you're losing $38 in interest by holding $670 in stock instead of cash.

Profit will become 80-38 = 42 on a max risk of 670 over 13 months, or 5.7% per year.

You'd be better off selling the 7.5 puts at .55. Profit would be 55+3 = 58 on 750 risk, or 7.1% per year.

This analysis never quite felt right to me. I think I finally figured it out. You still get to keep the $80 per year, you don't have to somehow give back $38. So you really do make 11.9%. But by "losing" 5.3% you should really be adding it to the amount you made.

I'm not stating this clearly (I'm in a hurry), but it should be that you could have made 17%, but you lost out on the interest, so you "only" make 11.9%.

 

[FullyArticulate]

Quote from Don87109:

I beg to differ a little bit. Many brokers do not pay decent interest on cash. Therefore many times a covered call is preferable to a NP.

Just looking at IB's margin requirements for this particular position...

Naked Put: $210 = $55 + $155. (The option's market value + 10% of the underlying's price)

Covered call: $1575 = $775 + $800. (100% of stock margin requirement + 100% of the in-the-money-ness of the option. I assumed a 50% margin rate for the stock)

The naked put ties up quite a bit less margin, not to mention your cash.

 

[FullyArticulate]

Quote from Eliot Hosewater:

This analysis never quite felt right to me. I think I finally figured it out. You still get to keep the $80 per year, you don't have to somehow give back $38. So you really do make 11.9%. But by "losing" 5.3% you should really be adding it to the amount you made.

Yes, correct. Option pricing makes the assumption that you borrow (or lend) the money at the risk free rate. A covered call will appear more profitable than an equivalent naked put because, in the former case, you're out cash that you could have been earning risk free interest on. In the latter case, you can be earning interest on cash that was "given" to you.

http://www.contingencyanalysis.com/glossary/articles/option_pricing_theory.htm
Skip on down to "risk neutral valuation".

You can also see that retail accounts which do not earn interest on their cash are at a significant disadvantage to "the big guys" who can when trading options. If you're not making the risk free rate on your earned premium, you're, in essence, undercharging for the sold option.

 

[DeltaSpread]

Quote from Don87109:

I beg to differ a little bit. Many brokers do not pay decent interest on cash. Therefore many times a covered call is preferable to a NP.

For example, IB does not pay interest on the first $10k of cash. Clearly if your account is small like this a CC is better.

Another example, OE only pays very low interest on cash (under 2%). In their IRA's they insist on liquidating the cash from the good interest sweep account for any cash secured NP's. Again CC's make more sense in that case.

I have heard that TOS has similar problems to OE in this regard.

Best bet is to know your broker policies and do the math to decide which is best (NP or CC).

Don

You are correct. Many brokers wont consider the equity maintenance being secured for a naked put position as "available capital" and you wont get the money market 4% return & instead will make pennies as it sits there securing the puts.

I was really looking at the benefit from a leverage perspective. In other words, selling the naked put usually is only 10% of the underlying + premium you pocketed +/- OTM value, so the rest of that could be utilized for trading between now and the long term expiration of the puts as opposed to dumping it all into the shares and getting no trading ability from those shares for over a year.

 

[Don87109]

Quote from DeltaSpread:

You are correct. Many brokers wont consider the equity maintenance being secured for a naked put position as "available capital" and you wont get the money market 4% return & instead will make pennies as it sits there securing the puts.

I was really looking at the benefit from a leverage perspective. In other words, selling the naked put usually is only 10% of the underlying + premium you pocketed +/- OTM value, so the rest of that could be utilized for trading between now and the long term expiration of the puts as opposed to dumping it all into the shares and getting no trading ability from those shares for over a year.

I am not sure that you would suffer "no trading ability for over a year". I think most brokers would consider stock a marginable security and, for example, you could sell naked contracts using the un-margined portion of the CC stock as "collateral". So you can still get some leverage, but just not as fully as having the cash instead.

Don

 

[mohitaron]

You can buy a stock and sell deep ITM covered calls on it to generate a nice monthly income. Alternatively, you can simply sell a naked put on that strike - its synthetically equivalent to doing a covered call. To get the most out of this strategy, find options where implied volatility is high compared to the stock's historical volatility - this ensures that options are expensive. One tool that I've found useful is the Dragon Tool from Optionsxpress - it lets you find stocks with low HV/IV ratio. You can access this tool for free through Yahoo Finance (Investing -> Options -> Option Dragon).