Rookie Questions on Covered Calls

[res123]

Thank you for the informative posts.

I just started Lawrence McMillan's book on options, and had marginal success with covered calls. I see the position as a "one unit", I'm trading on margin, and am neutral whether I get assigned.

1. I never held a position till expiration. What happens if you sell an OTM covered call (on margin), the underlying does not move much. The call expires worthless but what about the stock? I suppose I still own it in margin account (with lower cost basis) unless I sell the stock.

2. How would the situation differ if scenario in Q1 was selling of ITM covered call? I realize I made a mathematical mistake on premium collection in the OP.

I am not selling any naked calls as I don't feel I have the necessary knowledge or experience to rectify a rogue trade. Going through the posts here to learn more.

The question on Technical Analysis was for stocks, to see if there were any good sources. I can post it on the appropriate forum later.

 

[OptionsOptionsOptions]

1. I never held a position till expiration. What happens if you sell an OTM covered call (on margin), the underlying does not move much. The call expires worthless but what about the stock? I suppose I still own it in margin account (with lower cost basis) unless I sell the stock.

That's the ideal situation for a covered call. Stock trades flat, you still own the stock, call expires worthless.

2. How would the situation differ if scenario in Q1 was selling of ITM covered call? I realize I made a mathematical mistake on premium collection in the OP.

Look at it this way.

• You are selling your car for $5000.
• You give the buyer $1000.
• He then buys your car for $6000.

 

[tommcginnis]

Look at it this way.

• You are selling your car for $5000.
• You give the buyer $1000.
• He then buys your car for $6000.

No.
An ITM analogue to selling the car would be
☼ You are selling your car for a fair-market price of $6000.
☼ The buyer gives you $1300 for the right to buy the car for $5000.
☼ He then (exercises his right and) buys the car for $5000 before his option expires.


Cheese, Louise.....

 

[tommcginnis]

That's the ideal situation for a covered call. Stock trades flat, you still own the stock, call expires worthless.
Look at it this way.

• You are selling your car for $5000.
• You give the buyer $1000.
• He then buys your car for $6000.

Ha! Just for fun, we can correct your example a second way: the subject was for a covered call, but you describe giving the buyer $1000. And then he buys your car for a $1000 premium above a presumed $5000 fair-market price. What you have described is selling-price insurance: a put -- not a call. So! Tweak it a little, and....

☼ You are selling your $6000 fair-market value car, and are not getting any bids.
☼ To insure that you can sell it for at least $5000, you buy price insurance for $1300.
☼ You then (exercise your right and) sell the car for $5000 before your option expires.

Sweet.

 

[Magic]

I have a semi-related question about covered calls; decided to post here instead of making a new thread.

Basically I'm trying to conceptually understand why a slight premium exists for systematic index buy-writing (and put selling I suppose). I.e. the BXY shows better risk adjusted returns than SPY.

But I was under the assumption that the extrinsic value of an option [in this case OTM call] is priced based off current expectations of volatility, which prices it at the sum total of probabilities of it's value at expiration.

What additional component besides sum of probabilities of value causes the premium received when writing to over time exceed the PnL of the option at expiration? If it was only the sum of all probabilities wouldn't systematically writing OTM calls eventually show $0 profit in the long-run less commission costs/spread?

Just calling it risk premium for holding unlimited losses vs. fixed gain doesn't seem to make sense... because the standard deviation of the BXY is actually less than SPY, so you're not really holding more vol/risk. Where is the value coming from?

 

[spindr0]

The short call of a covered call is meant to be OTM - you want it to expire worthless. No point in an ITM covered call. Covered calls are too risk-averse.

You sell a short call strike in a covered call where it provides you with what you believe to be an acceptable R/R trade off (potential profit versus downside protection). It's not meant to be anywhere other than where you want it to be.

And you have it backwards. Covered calls are NOT risk averse. A covered call is synthetically equivalent to a short put. In both cases you have a limited profit potential and yet you bear all of the downside risk of the underlying (less the premium received). That's a lousy R/R ratio.

 

[spindr0]

IMO ..... They have very little risk. A stock going down isn't such a big deal. Brokers even have covered calls listed in Level 1


Option Trading Levels

• Level 1 Covered Call, Long Protective Puts.
• Level 2 Long call/put.
• Level 3 Spreads.
• Level 4 Uncovered or Naked.

LOLOL. Option trading levels are designed to protect the broker, not you. A covered call is Level 1 approval and a naked put is Level 4 approval. And yet, they have the same R/R since they are synthetically equal.

Your risk dismissal for covered calls is ridiculous (see 2000 and 2008).