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A
Look at the Play Book...
What's
a trader to do? Let's look at the four basic trades that
most stocks will present at any given time:
Go
Out
Sometimes
you don't want to write a call that expires in the current
option month and are willing to write a call that has
a life of 5 weeks or more, maybe even several months.
Writing a call that does not expire in the current option
month (the front month) is referred to as writing
out, since it is further out in time. All things
being equal, you get more premium for writing out, but
you are in the trade longer. As a general rule, you get
less premium the further out you go, so the return on
a monthly basis will usually be less than just writing
the front month. That is, a stock paying a 5% premium
this month at a particular strike will seldom pay 10%
if you sell the next month - and even if the next month
does pay a 10% premium, it is the same as a 5% premium
for a one-month hold, so it's not really more money, is
it? And if you write 4 months out, you won't get even
close to 4 times the premium you would get for just writing
the front month. We don't think that writing further out
in time is a bad thing, but you will consistently get
lower returns by writing out. At the end of the year,
trading success is about getting consistent base hits
(sorry for the baseball analogy) that add up to a big
return, so don't be blinded by what look like big returns
from writing more time - but really aren't.
| Next
Month Calls |
| Advantages |
Disadvantages |
| Writing
the next month or even further out pays the largest
dollar premiums. |
The
more time you write, the proportionally smaller your
returns will be. |
| |
The
farther out you write, the longer you are in the trade
and exposed to trading risk. |
| Strategy: |
| We're
not sure there is a good strategy for writing further
out. When buying options, you should never buy more
time than you need, and this is true for writing options,
as well. There might be a darkside strategy here for
writing covered calls, such as writing a deeply ITM
call several months out on a highly volatile stock
for a huge premium, expecting that as the stock drops,
the call can be bought back cheaply enough to produce
a profit (after taking the stock's price decline
into account). Sounds pretty far out to me. |
Go
Long
This
usage of the term "go long" refers to writing
a call that is out of the money, not
to buying a call. A call is out of the money when its
strike (exercise) price is higher
than the stock's current price. So when the stock is under
$14, any strike $15 and higher is out of the money. We
consider a call to be deep out of the money (DOTM)
when it is 10% or more out of the money. If you think
a stock is likely to go up and hit the strike price, the
DOTM is the call to write, because the out of the money
call is the only one that gives you a higher return if
you are called out of the underlying stock. On the other
hand, the DOTM call usually pays the smallest premium,
so if you are not reasonably confident the stock will
move enough to get you called out, this is the poorest
choice to write. In a bull market, the DOTM calls can
pay (and in the 90s bull market did pay) astonishingly
high premiums, but in a bearish market the premiums are
very low.
There
is another facet of OTM calls that is interesting, and
that is the opportunity to make a significantly higher
return on the OTM call, even if you are not called out
of the position. Remember, the return on an ATM or ITM
call is the same whether you are called out or not. But
this is never true with an OTM call. Consider four different
scenarios on an OTM call, in which you buy the stock for
$16 and write the $17.50 call for a $1.00 premium:
| |
Example
1 |
Example
2 |
Example
3 |
Example
4 |
| Stock
$16 at Expiration |
Stock
$16.50 at Expiration |
Stock
$17 at Expiration |
Stock
$18 at Expiration |
| Stock
bought |
-$16.00 |
-$16.00 |
-$16.00 |
-$16.00 |
| Premium
rec'd |
+$
1.00 |
+$ 1.00 |
+$
1.00 |
+$ 1.00 |
| Stock
sold |
+$16.00 |
+$16.50 |
+$17.00 |
+$17.50 |
| Final
Return |
6.25% |
9.38% |
12.5% |
15.61% |
It
is virtually certain in Example 4 that you will be called
out at the $17.50 strike if the stock is $18 at expiration,
although in that event you would only get the $17.50 strike,
no matter how high the stock was at expiration. But what
happens if the stock is less than the $17.50 strike at
expiration? It is clear that you will not be called
out in the other three scenarios if the stock
is $15, $16.50 or $17 at expiration. In those three examples,
because you are not called out you would have to sell
the stock to close the position. But notice how the OTM
call gives a profit at expiration in Example 1 but an
even better return in Examples 2 and
3. The better return in Examples 2 and 3 occurs because,
even though you were not called out, you still sold the
stock after expiration for more than you paid. The
OTM is the only call in which the stock can finish up
at expiration yet below the strike and still increase
your return on the trade.
| OTM
(out-of-the-money) Calls |
| Advantages |
Disadvantages |
| If the OTM calls are exercised,
you get the highest return of any call. Only the OTM
call gives you a higher return upon being called out. |
Except in a strong bull market,
the initial OTM premium (what you get upon writing
the call) is usually the lowest of all calls. The
farther OTM the strike price is, the lower the premium. |
| Unlike ATM and ITM calls,
OTM calls can give you a much larger return even if
not called out, if the stock is higher at expiration
than the entry price, even though not high enough
to get the position called out. |
Lower premium received upon writing
the call gives you the least protection against a
slide in the stock's price. |
| OTM calls will consistently give
the highest returns in a market that is strongly uptrending
or on stocks that are strongly uptrending (both is
better). |
Generally poor performance in downtrending
markets and downtrending stocks. |
| Loss of time value close to expiration
makes it possible to buy back the call for $0.05 to
$0.15 and unwind the trade by selling the stock. This
terminates trade risk and frees up trading capital
for a new trade. |
|
| Strategy: |
|
In order to justify the risks posed
by the low premium upon entry, you need a reasonable
chance of getting called out for a larger return.
OTM calls are best used on an uptrending stock in
an uptrending market. They also can work well on
range- bound stocks, meaning stocks that are trading
in a price range and not trending up or down. The
ideal time to write the OTM call is after the stock
has touched the bottom of the trading range (the
support level) and begun moving back up. For this
reason, write only stocks that pose a reasonable
chance of moving enough to put the OTM strike in
the money.
In a downtrending market the odds
are highly against the OTM call winning, and the
low downside protection makes it a poor choice.
Never write OTM if the stock is unstable or dropping
or if significant news is expected before option
expiration.
Because of the small downside protection
the premium gives you, never write an OTM call with
more than 4 weeks remaining until expiration. The
less time you are in an OTM trade, the better. |
Go
Short
This
refers to writing a call that is at the money
(ATM). A call is ATM when its strike price is
the same as the stock's price. As a practical
matter, a call is considered to be ATM if the strike is
pretty close to the stock price, since it will behave
like a true ATM option. While there will always be exceptions
to the rule, month in and month out, and year in and year
out, you'll get the highest return (not necessarily the
most premium dollar) at the money. The flat return and
if-called return will always be the same, except where
an ATM call is slightly in the money, in which case you'll
get a little more if you are called out, but not much.
| ATM
(at-the-money) Calls |
| Advantages |
Disadvantages |
| Consistently offer excellent returns
in both bull and range-bound markets. |
If the call is exercised, the return
will be the same as the flat return received on trade
entry. |
| ATM premiums provide moderate protection
against a downside price movement. |
Will consistently give lower returns
than OTM calls in a bull market. |
| Strategy: |
| In an
uptrending or range-bound market, ATM calls give
consistently good returns, though nothing generates
the profits that OTM calls do in a hot market.
ATM calls may not be a good strategy
in a downtrending market, when a stock is at a resistance
level and can be expected to decline, or in any
other circumstance where you expect a price decline. |
Go
Deep
This
refers to writing a call that is in the money,
which means that the strike price is lower
than the stock's price. We consider a call to be deep
in the money (DITM) when it is 10% or more in
the money. If you think a stock has a real likelihood
of going down, then the DITM is the call to write, because
the high premium gives you the highest cushion of all
the calls against a price drop. On the other hand, the
DITM call seldom pays the highest premium, so unless you
are uncertain about the market, the stock's sector or
the stock itself, the DITM is not a great choice to write.
The flat return and the return if-called will always be
the same. Because in-the-money calls are almost always
exercised, you don't have to worry about closing the position
and selling the stock after expiration. Nothing is more
frustrating to have a covered call trade work and then
have the stock drop on the open Monday morning following
expiration before you can sell it. Keep in mind, however,
that sometimes calls are not exercised when they are just
barely in the money.
By
the way, don't get confused by a large ITM premium. The
intrinsic value portion of the premium (the portion that
is in the money) is NOT considered in calculating the
return - only the time value portion constitutes return.
So in our example below, the DITM 30 call offers the largest
October premium ($6.20), but the lowest return - 1.86%.
And the reason for that is that the 30 call is $5.48 in
the money ($35.48 stock price - $30 strike), so only $0.72
of that big premium really is a return to you. However,
the entire premium is received when you write the call,
so this call gives you huge downside protection against
a drop in the stock price.
| ITM
(in-the-money) Calls |
| Advantages |
Disadvantages |
| The high ITM premiums
provide the very highest protection against a price
slide in the stock. |
The percentage returns from ITM
premiums tend to be consistently smaller than ATM
calls. |
| You will almost always
be called out of ITM trades, which provides the largest
possible return on the trade and terminates your trade
risk. (If
you are not usually called out of your ITM trades,
you'd better look hard at your trade selection criteria
!) |
If the call is exercised, the return
will be the same as the flat return received on trade
entry, so the original premium you received is the
best case for the trade. |
| Strategy: |
| Some traders
write ITM calls routinely despite the somewhat lower
returns than are available from writing ATM, because
they like the extra protection. If you are writing
10% or more in the money, you have substantial downside
protection. If you like a stock but are concerned
about it declining (you're unsure about the market
or concerned about news on the stock, etc.),
then the most conservative covered call strategy is
to write a deeply ITM call, because the huge premium
gives you the most protection against a price slide.
ITM calls also work well when writing range-bound
stocks that are at or close to resistance, meaning
that they are at the top of their current trading
range and therefore likely to fall back. |
Let's
do some analysis:
It
is always easier to look at tables to see these strategies
in action. For example, consider a stock that was on three
of our Real Time Lists™ one day:
OSI Pharmaceuticals (OSIP), which was
trading at $35.48. Here are the six possible
covered call plays it offered with acceptable returns,
three for October and three for November:
| Type |
Call
Series |
Premium |
Flat
Return |
Return
If-Called |
| OTM |
Oct.
40 Call |
$1.40 |
3.94% |
16.49% |
| ATM |
Oct.
35 Call |
$3.00 |
7.10% |
7.10% |
| ITM |
Oct.
30 Call |
$6.20 |
1.86% |
1.86% |
| OTM |
Nov.
40 Call |
$2.70 |
7.60% |
20.34% |
| ATM |
Nov.
35 Call |
$4.60 |
11.60% |
11.60% |
| ITM |
Nov.
30 Call |
$7.40 |
5.40% |
5.40% |
October
stock options will expire on October 17th, which would
mean 22 days in the trade. But November options will expire
on November 21st, which would mean 57 days in the trade,
almost three times the duration of the October calls.
In fact, 57 days really is two months, so any return for
that holding period should be divided in half to compute
the real monthly return on running a November trade now.
There is always more to consider than just the raw return,
so let's run down some of the trader's concerns based
on the potential trades in the above table and how to
analyze them. As the paragraphs below illustrate, the
choice you would make depends solely on how you view this
stock and the overall market over the next couple months:
1.
It's a no-brainer, right? This Oct.
35 premium is the fattest in the current month - - a 7.10%
return when you write the call and only a 22-day holding
period, so you'd be pretty tempted to seize on it. Although
technically $0.48 in the money, is close enough to the
stock price that it can be considered ATM. And the $3
premium, although not the largest premium offered, gives
you some meaningful protection against a price drop. But
if you are concerned about the market or this individual
stock, you have to ask yourself whether $3.00 is enough
protection.
2.
You are worried about OSIP holding its price.
This could be because it is showing weakness, or you expect
potentially bad news, or the stock is at resistance, or
for other reasons. If this is the case, don't even consider
the OTM call, because the $1.40 premium doesn't offer
a lot of protection in case of a drop, and if the stock
doesn't look likely to hold price, you are at high risk
of losing money on the stock side of the trade. And if
you're not called out, that 16.49% return will never materialize.
Better to write the ATM or ITM call, since the higher
premium protects you against a much bigger drop. The ITM
return is so small (despite the $5.20 premium), that you
would only write this one if really worried about the
stock. But if the $3 ATM premium is not enough, the ITM
write may be worthwhile.
3.
You're worried about the overall market.
If you believe the market is due for a significant pullback
(which likely will carry the stock with it, since a falling
tide lowers all boats), then the analysis in paragraph
2 above applies - write the ATM or ITM call.
4.
You see OSIP moving up significantly before expiration. If
you expect OSIP to move enough - by expiration - to put
the OTM 40 Call in the money and result in exercise, then
you should write the OTM. But the stock has to move nearly
$5 dollars in price to make the OTM win, and the move
has to occur within three weeks (22 days).
5.
Earnings news is due before expiration.
We really don't like to write these, and you shouldn't,
either. A stock can take a hard hit on poor earnings.
Most stocks get penalized hard when they don't make their
predicted numbers. In fact, they frequently get hit even
when they make their numbers but fail to make the higher
whisper number floating about. If you are going to write
stocks with earnings news due before expiration, better
stay ITM. Here's a tip: stocks frequently appear on our
Real Time Lists™ precisely because
the market believes that the company will exceed or fail
to meet its own estimate or the whisper number.
6.
Are those November calls really that fat?
No, they're not so great. You will be in the November
series calls almost three times as long as the October
calls, but the Novembers aren't even giving you twice
the return. Divide the percentage return by the number
of days held, and it is a real eye-opener. Time is money,
and nothing illustrates it better than the difference
between writing the front month and writing out. On the
other hand, you might want to write the OTM November,
figuring that the stock needs a little more time to move
up to the target price so that you get called out and
get the really big return.
Only
you can decide how much risk the trade presents, or how
much premium you need to justify the perceived risk. And
we know that traders have vastly differing styles. But
the foregoing points cover most of the points you'll take
into consideration in deciding which strike and which
expiration month to write.
What
would we do at CallWriter?
I can't say definitively, because I haven't thoroughly
analyzed OSIP as a covered call play. In particular, I
haven't looked at news or when earnings are due. Please
don't view the use of OSIP in this article as a recommendation
of any kind. It is just being used in our example, since
it handily offered so many potential trades. But all things
being equal, we would either write the ATM October 35
or pass. Why? OSIP went into a trading range several months
ago and shows none of the energy necessary to make the
OTM 40 call pay off. The ITM call's return of 1.86% is
just too small for a 3-week hold. And we don't like writing
58-day covered calls due to the extra time we are at risk
and due to the haircut you get on the yields, so we would
pass on the November options.
As
always, we trust you'll find this article helpful in your
own trading. We welcome article suggestions, since we
really like to cover topics of interest to you in your
trading.
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Disclaimer
We
are not brokers, investment advisers or securities
analysts and do not recommend the purchase,
sale or holding of any security. Your use
of any information or strategy appearing in
this newsletter or on CallWriter.com is solely
at your own risk. We urge our newsletter subscribers
and CallWriter.com website members to do all
requisite and analysis and properly plan each
trade prior to making the trade and to manage
each trade effectively. Covered call and other
potential trades discussed in this newsletter
or on CallWriter.com do not constitute trading
recommendations by CallWriter or any other
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