Rookie Questions on Covered Calls

[res123]

Hi All:

Hoping to be educated on some points.

1. When selling deep ITM covered calls (transacted on margin), isn't it possible in theory for the underlying to be assigned right away. If XYZ is trading at 205, and if you sell a covered call for 195 for 30 days expiration while getting $7 for premium, why wouldn't a holder/market maker exercise it instantaneously to make a $10 (205 - 195). What am I missing?

2. Besides the P&L profile, what are some of the advantages and disadvantages of selling ITM v OTM covered calls.

3. Is covered call a cost effective method to purchase the stock versus other strategies. If I don't have the money just now, Sell a covered call (margin), and buy back the call close to expiration hopefully at a profit and retain the stock and pay it with my own funds or continue to hold it on margin.

4. This strategy does tie up a lot of cash in margin, are there any equivalent strategies to minimize cash tie up. Would you recommend this strategy for someone with minimal experience. Typically I would do this only on stocks that I don't mind owning for long term.

5. Is there any role of delta hedging on this, especially where the risk is defined somewhat (I don't anticipate Apple or FB to be bankrupt in 45 days).

6. What educational tools (books, courses, etc) would you recommend to learn technical analysis.

A big thanks in advance!

 

[Robert Morse]

1. When selling deep ITM covered calls (transacted on margin), isn't it possible in theory for the underlying to be assigned right away. If XYZ is trading at 205, and if you sell a covered call for 195 for 30 days expiration while getting $7 for premium, why wouldn't a holder/market maker exercise it instantaneously to make a $10 (205 - 195). What am I missing?

Yes they can, but they need a reason to add the addition risk and margin with the equity vs the option. Typically, 2 reasons for early assignment are hard to borrow stocks and high dividends.

2. Besides the P&L profile, what are some of the advantages and disadvantages of selling ITM v OTM covered calls.

It would be based on your expectation of where the stock will trade. Way to complicated to get answer this way.

3. Is covered call a cost effective method to purchase the stock versus other strategies. If I don't have the money just now, Sell a covered call (margin), and buy back the call close to expiration hopefully at a profit and retain the stock and pay it with my own funds or continue to hold it on margin.

I hate covered calls in general.

4. This strategy does tie up a lot of cash in margin, are there any equivalent strategies to minimize cash tie up. Would you recommend this strategy for someone with minimal experience. Typically I would do this only on stocks that I don't mind owning for long term.

The response would be based on assumptions we can't make for you.

5. Is there any role of delta hedging on this, especially where the risk is defined somewhat (I don't anticipate Apple or FB to be bankrupt in 45 days).

I do not think you are ready for selling extra options naked to delta hedge, but again it would be based on your assumptions that only you can make.

6. What educational tools (books, courses, etc) would you recommend to learn technical analysis.

If all you care about is TA, you can look for a mentoring program that teaches that.

There are no easy answers to option questions that require assumptions and expectations that are part of your process.
Bob

 

[tommcginnis]

1) If you're selling a $10 ITM CC, the call premium will be more than $10, not less.

2) An oft-cited risk of selling CCs is the same as owning outright: the risk of loss should the underlying drop. By entering an ITM CC, you lower the basis of ownership by that call's premium amount, and therefore lower the risk. Risk-of-loss remains, but it is reduced. To really get the feel for what's going on, graph this stuff out. YOU can then decide where the greater expected risk is, for that stock, in that period of time, and for your situation.

3) Graph it. There is no fixed answer -- even for you, as your own situation will change over time. Selling puts (on stock you wish to own) has a small statistical edge, but CCs have a nice feel to them, too (for some).

4) Creating synthetic longs and shorts with options can minimize the immediate need for cash, however, you have to re-create the position with each expiration, which adds material trading costs to positions in which a percent or two of return can make a big difference. People with retail accounts mostly don't.

5) You're going to hedge a hedged position? Shouldn't you then hedge your hedged-position hedge? Where does it end? Oh, the Humanity!

6) How can I get that cute girl at the end of the bar to even meet my (adoring) gaze? Oh, wait: separate subject -- belongs in another thread -- like T/A.

 

[Pekelo]

#4. Sell vertical calls. By buying a higher up call the margin is way, way less. You do limit your profits though...

 

[El OchoCinco]

Hi All:

Hoping to be educated on some points.

1. When selling deep ITM covered calls (transacted on margin), isn't it possible in theory for the underlying to be assigned right away. If XYZ is trading at 205, and if you sell a covered call for 195 for 30 days expiration while getting $7 for premium, why wouldn't a holder/market maker exercise it instantaneously to make a $10 (205 - 195). What am I missing?

As pointed out, your first mistake is misquoting the call price at $7 when it should be $10 minimum. If you sell a CC with time value premium then geting assigned right away can be quite beneficial.

 

[spindr0]

A covered call is synthetically equivalent to a short put. Selling puts may reduce frictional costs if the underlying cooperates (you pay fewer B/A spreads and fewer commissions).

Covered calls and short puts have an assymmetric pay R/R. You bear all of the risk and you only have the potential for a small reward. Sell vertical spreads instead to significantly reduce risk as well as the margin required.

If you must, sell CC-s when you have a target exit price for long stock (the short strike) and you want some income while waiting for price to get there. Sell short puts to acquire stock that you WANT to own at a better price.

Disadvantage of selling an ITM CC are

(1) Loss of stock that you want to keep

(2) B/A spreads tend to be wide so you may get screwed on fair value going in and possibly out, should you want change your willingness to sell.

(3) There are rules dictating Qualified versus Unqualified covered calls so there may be adverse tax implications

Selling CCs on margin just means greater risk and greater reward due to increased position size versus account size. Playing the margin game (with hope) when you have insufficient funds is a disaster waiting to happen.

Delta hedging applies where you want to limit risk. It's small ball versus hitting a home run or striking out. It's also easier said than done since retail commissions and the spread are impediments.

I'd suggest that you pick up copies of "Options as a Strategic Investment" by Lawrence G. McMillan and "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg before spending a lot of time studying technical analysis. Read them. Then read them again.

 

[OptionsOptionsOptions]

Hoping to be educated on some points.

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.
• Once you try one you most likely will not trade them again.

 

[Robert Morse]

Covered calls are too risk-averse.

I’m going to respectfully disagree. I’d say covered calls have a lot of risk and very little reward. What is the point of being a stock picker if you’re always going to limit your gains. This is why I hate but-writes in general.

 

[OptionsOptionsOptions]

I’m going to respectfully disagree. I’d say covered calls have a lot of risk and very little reward. What is the point of being a stock picker if you’re always going to limit your gains. This is why I hate but-writes in general.

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.

==== EDIT ====

• FB at $192.40
• 100 shares $19,240
• Sell July13 195.00 call $3.30

• Stock drop 10%
• Loss is only about $1,600

 

[El OchoCinco]

Broker's allowance of trades has nothing to do with risk in the position, it has to do with margin and exposure. CCs have no risk for the broker because you are holding the stock already and if the stock goes to $0, broker has no worries about margin/risk.

Buying a stock has risk and selling a call does not minimize that in any significant way.

Your example by the way shows that the CC only cushions the risk slightly in exchange for giving up all upside.