While this is a simple strategy, it isn’t for everyone.
One of the more simple option strategies available to traders who purchase stock involves “selling or writing calls” against the shares that we already own. We receive a premium from the “buyer” in exchange for their right to “call” the shares away from us at some future date.
In this example we will use Activision (ATVI), a stock from the weekly 8/28/2016 watch list, using the initial entry, 41.25 or better.
We are bullish the stock so we assume our shares will continue to increase in value. The “risk” in taking this position is two-fold.
1) as the call “writer”, the stock can be called away or
2) the stock could drop in value.
Having our shares called away isn’t a problem because we expect to sell at a higher price anyway. A sudden drop in price would represent a drawdown. This risk can be “hedged” by buying out of the money (OTM) puts.
If we own 1000 shares of ATVI, our original cost basis is 41.25 or $41,250. As we consider this transaction, we have to weigh selling covered calls against a gross profit to date of $4750, the difference between 41.25 and 45.00 = 4.75 x 1000 = $4750). We could sell now and take the profit or we could keep our shares a while longer and sell covered calls.
Why sell covered calls, if we’re already profiting handsomely?
We could argue, since are ready to sell anyway, we could sell covered calls when presented with the conditions below. If we weigh the pros and cons, we have potential to rake in more income.
Our reasoning and thought process is as follows:
As the option writer, we have a few things to consider.
First, our upside is limited should we decide to employ this strategy, as you’ll see below.
Second, we need to measure our risks and decide if this is a course of action we are willing to take for a premium.
We have the risk that prices will continue higher and our shares will be “called away” limiting our original position to further appreciation beyond the strike we choose. That said, we already want to sell, so why not make another $2100.00? See below.
Third, if we decide to take the trade, we also need to acknowledge volatility and average true range, as well as RSI.
Where is the best place to sell covered calls?
From our perspective, selling covered calls against our shares is best done when we expect volatility will decrease in the near term. In other words, we want to see Bollinger Bands wide and changing direction, moving back towards price. This signals implied volatility will start to decline.
Look at point “B” on the chart above. Bollinger bands are at their widest. Also note RSI is near or above 70. MACD is dropping as well, telling us bullish momentum is subsiding. The likelihood prices will fade are high, so we are selling our covered calls at what we consider the best price, receiving the highest premium, hindsight being 20/20. Additionally, we know ATR is less than 1.00, so we have a sense of how much the stock will pull back.
If we were selling these covered calls on Thursday, we would receive 2.10 per covered call using the NOV16 expiration and 45 strike. Our preference is to sell as close to “at the money” (ATM) as possible. The farther out of the money, the less premium you receive, making a sale not worth our time. The stock closed the week at 44.36.
Since we have 1000 shares and each option represents control of 100 shares, we can sell 10 covered calls and collect $2100.00 ($2.10 x 10 x 100 = $2100). We keep the premium and the shares if nothing happens.
If prices fade very little from here, we can buy these covered calls back at a discount as theta kicks in. In this scenario, we still own the shares and we keep the “covered call” premium. If we are still bullish and ATVI bounces, we could repeat the process, collecting more “income.” This repeatable process is the jest of this blog post, writing covered calls and collecting income.
Wait a minute Vinny, what if ATVI drops in price?
All things considered, we are willing to take the risk for $2100.00, so if we thought ATVI would decrease more than 2 dollars (2 x the Average True Range) we could hedge with some OTM puts.
We’ll buy 10 OCT16 puts at the 42.00 strike, 2.50 dollars OTM for 0.32/contract.
(0.32 x 10 x 100 = $320.00 debit)
$2100.00 – 320.00 = $1780.00 credit from the transaction and we’re protected from any sudden drops.
If for some reason ATVI dropped the full 2.5 dollars, we could sell our puts for a profit, retain the covered call premium of $1,780.00 and still own the 1000 shares.
What if I don’t own the shares from the initial entry, but just want the income? I have $45,000 sitting around making 1.00% interest. Can I do better by selling covered calls now?
Sure you can and many people do exactly that. If we didn’t already own the shares and wanted to buy on Thursday, we could buy 1000 shares and immediately sell 10 covered calls as part of one transaction. Our return will be much greater than any money market fund or CD will pay. In both cases we are looking for extra income.
In the above example(s), if the stock moves to 47.00 on or before November expiration, the trader who bought our calls, has the right to call away our shares at 45.00, capitalizing on the +2.00 difference. We would deliver our shares at 45.00, hence the reason for the premium we received in writing these calls.
Finally, we’d like to point out that this strategy is not meant to capture all the caveats and nuances of options trading, nor is it the only strategy you could employ for extra income. This is a simple concept, where we hope to plant a seed, whereby you are induced to seek capital appreciation in all of its forms.
For more on options strategies, including “Covered Calls” follow this link.
Do your own research. It’s your money!
Happy Trading – CV
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