September 25, 2003

Go out, go long, go short or go deep?
Deciding which call option to write.
By John Brasher, CallWriter.com Publisher

 

Forgive the football analogy... it's that time of the year, and we like football as much as anybody. One question we get a lot is how to write covered calls when more than one call on a stock offers an acceptable return. It is a fair question, because a stock with fat call premiums frequently will present several possible trades when several different call series (different strike prices) are paying good returns. In fact, we see this on CallWriter's Real Time Lists™ of the highest-returning covered calls frequently.

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.

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:

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.

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.

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.

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:

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.

Good luck and good trading!