Question about covered call

Derrenoption · Apr 1, 2017

Hello

I have a question about covered calls.

There is a question that keeps coming to me all the time. Looking
at this picture that shows 3 scenarios.

Let us assume that we sell the call options ATM.
http://www.bilddump.se/bilder/20170401204424-195.252.32.111.png

Let me take the scenario to cover the question. Our account size is
exactly $50000.
1. Thursday: We buy 1000 TNA for 50$ = $50000
2. Thursday: We sell 10 calls for 142$ = $1420 (Premium income no matter
what)

Now let us assume that the price next Thursday(6 days later) has gone up
to $60.
This means a loss of: $10000 - $1420 = $8580

Now is my question. As we have all the money on the account in the ETF TNA
and we now owe $8580.
My big question is, what practically happens in this scenario? I know that we have
made up the loss as the ETF TNA has gained in value. That I understand,
but doesn't this mean that we must sell shares of TNA to make up the loss
as we don't have any cash in the account to cover the loss or do I miss anything?

Thank you in advance

JSOP · Apr 1, 2017

Derrenoption said:
That I understand,
but doesn't this mean that we must sell shares of TNA to make up the loss
as we don't have any cash in the account to cover the loss or do I miss anything?

Thank you in advance

No, it's because you don't have enough SHARES in your account IF you sell the shares to get the profit of $10000. What you describe is when you write a Put option and the price drops against you then if you don't have enough cash, you are going to have to NOT sell the shares but borrow on margin to cover the cost.

In this scenario, you have enough shares so your shares would just get removed from your account to be delivered to whoever bought your calls and chose to exercise their calls. You are going to end up with $0 profit from the stock because your shares are going to be taken from you and sold at the strike price of $50 since the call is ATM and just with a premium profit of $1420 from the calls unless you close your short call position before cutoff on the expiration date but then your profit on writing calls will be less than $1420, it will be (closing price - $1420) when you close the position and then you can sell the stock for profit get $10K.

Now if you choose NOT to close the short call position because you want to hold onto the $1420 call premium profit and still sell the stock to get the $10K, then you will be stuck with a short position for that 1K of shares when the options are exercised against you because your broker will still try to take shares from your account to fulfill your obligation as a call writer but since you sold your shares and don't have enough in your account, then the broker will lend you the shares and you will be in a short sale position and if the stock go up even further then you will be suffering losses for every penny that the stock price goes up.

Lee- · Apr 1, 2017

I think you're missing what happens when the options are exercised -- you have created a covered call situation. The stocks you hold in your account are covering the contractual obligations of the calls. If your options were assigned, the broker could potentially use your shares to satisfy those calls, leaving you with a cash balance of $51,420 (ignoring all commissions and fees).

You may want to consider the case where you sell some or all of the shares without closing your options position.

Derrenoption · Apr 1, 2017

Yes, the scenario I only think about at this moment how it will work practically is if I Buy back the option (Assuming that the stock doesn't get called away)

So if the stock is at $60 and we bought it for $50 dollar and we get a premium of $1420.
Assuming that when buying back the option we get let us say: 1300$.

This is my question now:

1. We got 1300$ in premium
2. We also have a loss on the option of $1300 - $10000 = -$8700
3. We have a profit on the stock of $10000

So we have not have our stock called away. What happens EXACTLY at the moment in the account when we buy back the option. Because shouldn't we in somehow have a loss in CASH when we buy back the option because our $10000 of profit in the stock is TIED into the stock itself?
Shouldn't we have to pay for this -$8700 loss in someway. But there is no CASH in the account since everything is TIED into the stock?

Lee- · Apr 1, 2017

Derrenoption said:
Yes, the scenario I only think about at this moment how it will work practically is if I Buy back the option (Assuming that the stock doesn't get called away)

So if the stock is at $60 and we bought it for $50 dollar and we get a premium of $1420.
Assuming that when buying back the option we get let us say: 1300$.

This is my question now:

1. We got 1300$ in premium
2. We also have a loss on the option of $1300 - $10000 = -$8700
3. We have a profit on the stock of $10000

So we have not have our stock called away. What happens EXACTLY at the moment in the account when we buy back the option. Because shouldn't we in somehow have a loss in CASH when we buy back the option because our $10000 of profit in the stock is TIED into the stock itself?
Shouldn't we have to pay for this -$8700 loss in someway. But there is no CASH in the account since everything is TIED into the stock?

You're missing some key concepts. You don't "lose" or "gain" on a trade until the position is closed. You have unrealized profit or loss. If the options are called away, then you have no outstanding position. Your 1000 shares were taken by your broker to satisfy the call options you sold and your options position is now closed as well -- so you have no stock or options position in this case. You only have $51420 in cash (minus any commissions and fees).

Alternatively, you can close your option position before it is exercised by buying the contracts back. At this point you would no longer have an options position. It's like if you bought stock for $50 and then sold it for $40. The moment you sell the stock, you have no position. Your losses happen because you sold the stock and you are out of the position. You lose because you sold for less than you bought. The option works similarly. The act of closing your options position would require you to buy 10 options contracts (and they will be more expensive than when you sold them, which creates your loss).

Where did this $1300 come from? You said you sold call options with $50 strike for $1420. 6 days later the stock is $60. Are you saying in this case you could buy the call options (to close your position) for only $1300? I can't tell you what they would cost exactly, but the intrinsic value alone in those 10 contracts would be $10,000. This breakdown is as follows:
($60 - $50) * 100 * 10 = $10,000. There will still be extrinsic value as well (time and volatility). With a huge price move ($50 -> $60 in only 6 days) there would likely be a lot of volatility value (unless it was near expiration).

To make it clear -- to close your options position before they are exercised would require you to purchase 10 contracts back for a total cost of greater than $10,000. This act of closing your options position is what incurs your loss because you are buying them back for way more than you sold them for.

Derrenoption · Apr 1, 2017

Alternatively, you can close your option position before it is exercised by buying the contracts back. At this point you would no longer have an options position.

This is the Only scenario I am wondering about now.

The act of closing your options position would require you to buy 10 options contracts (and they will be more expensive than when you sold them, which creates your loss).

Yes, this I understand, which still is my question that I have not really understand fully yet.

Where did this $1300 come from? You said you sold call options with $50 strike for $1420. 6 days later the stock is $60. Are you saying in this case you could buy the call options (to close your position) for only $1300?

The total time value of the options were $1420 but, let us say I am buying the options back 1 day before expiration. So we don't get the full timevalue. So we could say we get $1300 of the premium itself.

Let me ask the question again because it seems that I miss something. This is the scenario:

1. The account has $50000. We have bought 1000 shares of TNA for $50. Now ALL of the money in the account is TIED in shares. So there is no cash left in the account.

2. We sell 10 options and we will receive $1300 in premium.

3. Stock goes up to $60 dollar after 6 days on Thursday. Now we Buy back the option.
- We now still have the 1000 shares of TNA in the account
- We have realized a profit from the premium of $1300
- We have realized a LOSS from the option which is -$10000

Now is the situation in the account this. We have 1000 shares of stock. But we just realized a loss of:
$1300 - $10000 = -$8700

My only question now is. How will we pay for this -$8700 loss. There no actual cash in the account. All cash is TIED up in the stock?

Lee- · Apr 1, 2017

The price of an option is intrinsic value + extrinsic value.

Intrinsic value is the profit from exercising them. When you sold them, they had $0 intrinsic because they were at the money (exercising a $50 strike option when the underlying is $50 results in $0). Once the underlying is $10 higher than the strike, they have $10/share ($10,000 total) intrinsic value. Extrinsic value is primarily time and volatility. So while your options will have less time value 6 days later, they will have more volatility value. Which is why I said the cost to buy back the options would be at least $10,000. The point is, it would cost you over $10,000 to buy them back and this where your loss closing the option position comes from.

Now as far as how to pay for the $8700 or whatever the amount happens to be (it will actually be greater, but just for simplicity we'll go with this).

The fact is, you need $ to buy something. This $ can come from the following:
1) You sell some of the stock
2) You enter a new short position (ie sell some more calls) to get more cash with which to buy back the options
3) You deposit more money
4) (if you have a margin account) you borrow money from your broker.

JSOP · Apr 2, 2017

Derrenoption said:
Yes, the scenario I only think about at this moment how it will work practically is if I Buy back the option (Assuming that the stock doesn't get called away)

So if the stock is at $60 and we bought it for $50 dollar and we get a premium of $1420.
Assuming that when buying back the option we get let us say: 1300$.

This is my question now:

1. We got 1300$ in premium
2. We also have a loss on the option of $1300 - $10000 = -$8700
3. We have a profit on the stock of $10000

So we have not have our stock called away. What happens EXACTLY at the moment in the account when we buy back the option. Because shouldn't we in somehow have a loss in CASH when we buy back the option because our $10000 of profit in the stock is TIED into the stock itself?
Shouldn't we have to pay for this -$8700 loss in someway. But there is no CASH in the account since everything is TIED into the stock?

You can sell the shares for $10K profit first so you can cover the losses that you will incur in buying back the calls if you don't want to put in more money or borrow more money from the broker on margin. Yes when you buy back the options, you will have a cash loss.

As long as you buy back the options before the cut-off time before expiration you are fine.

Illini Trader · Apr 2, 2017

JSOP said:
You can sell the shares for $10K profit first so you can cover the losses that you will incur in buying back the calls if you don't want to put in more money or borrow more money from the broker on margin. Yes when you buy back the options, you will have a cash loss.

As long as you buy back the options before the cut-off time before expiration you are fine.

This suggestion will not be a possibility for you because your broker will not let you sell your shares with no cash left in the account. That would leave you in a naked short call position and to sell naked options you have to have an enormous amount of cash in your account plus be approved by the broker to sell naked options. The reason for this should be obvious because: "in a naked call position there is no limit to your liability".

The OP is making a very simple situation too complicated.

1. You buy the equity
2. You sell the call above the current price and the cash is deposited to your account
3. If the price goes above the strike price of the call your stock will be sold at the strike price.

You have no other choices because without any additional cash in your account you cannot buy the option back at a loss. It would be a null event anyway as the gain in the stock is offset by the loss in the option.

Derrenoption · Apr 2, 2017

This post should be red quite carefully to understand the examples exactly. This post boils down to:
QUESTION1 and QUESTION2.

You have no other choices because without any additional cash in your account you cannot buy the option back at a loss.

For example, if the margin is $120,000 as the stock itself is worth $60,000 and having a loss on the option of -$8,700. Wouldn't that be possible to use the margin in this case?

As the stock gain and loss in the option is a null event, this leaves us altogether at the moment with a small gain. It would be the premium: $1300

To keep in mind for below trading scenario idéa question (gain from $50 to $60 = 20% gain in the stock)

Now I am taking a trading scenario. (I assume that we can have the cash loss or -$8700 on margin and keep the 100 shares?)
As we have $1300 in profit at the moment. Now let us assume that we sell a new option for $1300. The stock will now decline to $50 again the next 6 days.

The scenario should then be:
1. $50 * 1000 shares = $50,000
2. Option cash loss on margin: -$8700 + $1300(premium) = -$7400

Total worth: $50,000 - $7400 = $42600

QUESTION 1
So we are back to where we begun at $50 a share but our total worth is now only: $42600?

.........................................................................................................................................................................................

Now I am thinking of another idéa with the above scenario in mind to see if it is possible to do a better approach using the --same procent-- amount of premium as above example.
Instead of buying only 1 stock, we will buy 5 different companies to diversify the risk of huge gains.
The scenario would behave like this the coming 6 days:

1. 1000 shares of Stock A á $10. Option strike $10 with premium: $260 (% gain next 6 days: 20%)
2. 1000 shares of Stock B á $10 Option strike $10 with premium: $260(% gain next 6 days: 1%)
3. 1000 shares of Stock C á $10 Option strike $10 with premium: $260(% gain next 6 days: 2%)
4. 1000 shares of Stock D á $10 Option strike $10 with premium: $260(% gain next 6 days: 3%)
5. 1000 shares of Stock E á $10 Option strike $10 with premium: $260(% gain next 6 days: 4%)

Procent premium: $260/ $10000 = 2.60%
Total premium: $260 * 5 = $1300
Average % gain in stocks: (20% + 1% + 2% + 3% + 4%) / 5 = 6%

We should now have this TOTAL option cash loss when buying back:
1. $10000 - $12000 + $260= -$1740
2. $10000 - $10100 + $260= $160
3. $10000 - $10200 + $260= $60
4. $10000 - $10300 + $260= -$40
5. $10000 - $10400 + $260= -$140

TOTAL option cash loss after 6 days: -$1700

Now let us assume that we sell new options for $260. All stocks will now decline back to $10 again the next 6 days.

The scenario should then be:
1. All 5 stocks worth: $10 * 1000 shares * 5 companies = $50,000
2. Options cash loss on margin: -$1700 + ($260 * 5)(premium) = -$400

Total worth: $50,000 - $400= $49600
.........................................................................................................................................................................................

QUESTION 2
So we are back to where we begun at $10 a share but our total worth is now worth as much as: $49600 compared to $42600 in scenario 1?
My question here. By diversify with many stocks and lower the risk of huge swings on average on the upside we could lower the risk to have lower cash option losses exactly as described in my SECOND scenario, - and by this more safe to keep the shares and have the opportunity to use the margin for the option cash losses?