I was wondering what is the risk level of writing deep OTM calls on an index such as SPY.
For example, the current price for a $150 JAN 18 2013 call on SPY (european-style option - so exercise is on expiry day only) is around $1.90. So, that is around around a 380 day holding period and assuming a margin of 10% * $122 = $12.2 (or $1,220) per sold call) required, that translates to an effective 15.5% return (or 14.9% annualized).
If the SPY were to start to creep up in price prior to expiration, I could avoid taking a loss (realized or unrealized) by simply buying 100 shares of the underlying (SPY) in the open market, to turn the trade into a covered call and effectively close the position (as opposed to buying back the sold call at a higher price which would turn into a realized loss), and then sell the SPY after the expiration date. It would be highly unlikely for SPY go gap up by 20% in one day and in any case I could always buy the SPY shares in the market to cover since this is an european option.
This means that I would keep on hand 100 shares * $150 * 50% initial margin = $7,500 of capital for each sold call in the unlikely scenario in which I had to convert the naked call into a covered call (or lower capital if portfolio margin is used). In this scenario, my only real risk would be that the price of SPY first goes way up, thus compelling me to turn the naked call into a covered call, and then goes way down prior to the expiration date.
Is this concept of being able to close out the position without taking any loss by simplying buying the underlying at the current market price 'too good to be true' somehow? Did I miss something in my analysis?
For example, the current price for a $150 JAN 18 2013 call on SPY (european-style option - so exercise is on expiry day only) is around $1.90. So, that is around around a 380 day holding period and assuming a margin of 10% * $122 = $12.2 (or $1,220) per sold call) required, that translates to an effective 15.5% return (or 14.9% annualized).
If the SPY were to start to creep up in price prior to expiration, I could avoid taking a loss (realized or unrealized) by simply buying 100 shares of the underlying (SPY) in the open market, to turn the trade into a covered call and effectively close the position (as opposed to buying back the sold call at a higher price which would turn into a realized loss), and then sell the SPY after the expiration date. It would be highly unlikely for SPY go gap up by 20% in one day and in any case I could always buy the SPY shares in the market to cover since this is an european option.
This means that I would keep on hand 100 shares * $150 * 50% initial margin = $7,500 of capital for each sold call in the unlikely scenario in which I had to convert the naked call into a covered call (or lower capital if portfolio margin is used). In this scenario, my only real risk would be that the price of SPY first goes way up, thus compelling me to turn the naked call into a covered call, and then goes way down prior to the expiration date.
Is this concept of being able to close out the position without taking any loss by simplying buying the underlying at the current market price 'too good to be true' somehow? Did I miss something in my analysis?
