What to Do with a Covered Call when the Stock Goes Up

Before I ever write a covered call, I make sure that I would not mind parting with the stock at the strike price.  I usually only write them on stocks that have gone up a lot in my portfolio, that I still think have good longterm appreciation potential (meaning that the company is still doing well at their business and have room to grow), but that have gotten too pricey for their current value.

For example, I recently wrote some covered calls on BJ’s Restaurants International.  I had bought the shares at somewhere around $20, I thought the stock was expensive at $45, but then the price continued to climb to around $60.  With a PE approaching 50, it was clear that although this is a great, growing company, it will take a while for earnings to justify the high price.  Rather than wait around for earnings to grow, I decided to write some covered calls and gain an income from the stock.

As it happened, the stock did go higher, and as expiration date approached it was a couple of dollars above my strike price.  (Note, options can, but almost never are, be executed before the expiration date.  Typically, however, they are executed just before expiration, so you are usually safe to wait until at least the week of expiration before taking action.)  In this case I analyzed the stock price and decided that I would not buy the shares at that price, so why should I close the position and effectively raise my cost basis.  I decided in this case to go ahead and let the shares be sold.  I bought back part of the position a few weeks later for about $10 less per share.

If I had decided that I didn’t want to lose the shares – for example if doing so would trigger a tax bill I didn’t want to pay, or if I would probably just buy the shares back at the current price and the cost of commissions for buying back the shares exceeded the cost of trading options, I might close the option position by buying an offsetting call option.  While this might cause a loss (depending on the premiums you collected when you wrote the calls and how far above the strike price the stock is), you are generally trading cash for the stock at a higher price.  In other words, you are increasing your effective cost basis on the stock.

For example, supposed you sold Jun $50 calls on XYZ corp and the stock went to $52.  Near expiration, the price of the call would be somewhere around $2.10 – the difference between the current stock price and the strike price, plus a small premium for the remaining life of the option.  If you were to close the position by buying an offsetting Jun $50 call, you would be paying $210 per option plus broker fees.  If you sold the calls originally for $1.20, you have now increased the amount you have in the stock by $2.10 – $1.20 = $.90 per share.  Note that the stock is also higher in price, so you really didn’t lose the money (yet), but you are increasing how much you have in the stock.  You should therefore ask yourself if you would buy the stock at the current price.  If not, let the stock be called away.  If so, then cover the position.

Another thing that can be done to offset the loss is to “roll the option” to a higher strike price and a later expiration date.  In our example, let’s say that you see the August $53 call is selling for $1.50.  You could close your Jun $50 calls and write an August $53 call.  This would increase the price at which you would lose the shares, giving you another dollar of breathing room, and the $1.50 in premiums you would collect would offset the price you are paying to close out the position.  Note there is a slight risk here that your existing option could be executed before you close the position, particularly if you are very close to expiration.  In that case you could end up with a naked call rather than a covered call – a very precarious position.  It would be a good idea to verify with your broker that you have not been assigned an execution before writing the new calls.

Finally, there is another reason you might wish to close the position.  Because a written call looks like short interest in your account, a stock that has gone up far above the strike price may cause your account to go into margin.  You are then paying interest and are possibly subject to a margin call even though the increase in the stock price will offset the loss on the call directly.  If this is the case, and it is a while until expiration, the best strategy is to close the option position and sell the shares to make up the deficit rather than waiting for the option to be executed.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Writing Covered Calls – An Example

A while back I spoke of covered call writing, which is one of the only ways anyone should use options.  (The other way is to protect a position from a loss by buying a put against an open position – essentially buying insurance on a stock.)  When one writes a covered call, you write a legal contract that will allow someone else to buy the shares from you at a specified price (the strike price) before a specified date (the expiration date).  In exchange, they buyer of the calls gives you money (called a premium).

I typically don’t write covered calls because I find I almost always can do better just holding the stock.  About a week ago, because the return was just too great, I went ahead and wrote a call on some Aflac stock I own.  The stock was trading at about $44.5 and the January calls, expiring on January 21st – about three weeks away – were selling for a premium of $1.10 per share.  This means I would receive $110 for each call I wrote (a call option comes in 100 share increments).

If the stock does not close above $44 per share by the 21st, it is likely that the call buyer will let the call expire worthless, meaning I’ll get to keep the premium.  If I could do this every month for the next year, I would earn about $110*12 = $1320 for the year – about a 30% return.  Considering I was only writing a call for 3 weeks, the return was actually closer to 40%.  Not many stocks go up 40% in a year, so it was a really good return.

If the stock goes up, once it moves above $44 per share I will no longer be making any more gain on the appreciation since the call buyer will be likely to exercise the calls and buy the shares at $44 per share.  Today the stock is at about $44.30, so I will likely lose the shares if the price stays high.  I will still make a profit since I’ll get to keep the premium and receive more for the shares than I paid for them if the calls do get exercised and I lose the shares.  If the stock goes to $50 a share, however, I’ll be kicking myself since I’ll only receive $4400 + $110 – $4510 per hundred shares and I could have sold them for $5000 if I had not written the calls.

The bigger danger, however, is that the stock may drop in price.  If it drops below $42.90 per share, I would have been better off to simply sell the shares at $44 per share.  The good news though is that I will have lost less than if I had just held the shares outright since I will have received the money from the premiums.  The bad news it that I’ll then need to decide if I want to write additional calls at a lower price – $42 per share say - and possibly lock in the loss, or wait until the price recovers a bit before writing calls.

Keep following and I’ll update my progress on the position as we get closer to next Friday when these calls expire.

Please send investment questions to vtsioriginal@yahoo.com or leave them in a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Risks of Derivatives: Options, LEAPS, and Warrants

Options, LEAPS, and warrants are all derivatives, which means that they derive
their value from the value of some other equity.  Derivatives by
their nature use a great deal of leverage, and therefore are
extremely risky.  In particular, all of these types of assets are
wasting assets, meaning that their value declines with time.  Not
only do you need to be right, but you need to be right within a
certain amount of time.  If the stock doubles in price the day before
expiration of your options, you may make a fortune.  If it doubles
the day after, you lose the entire position.

The advantage of using such leverage is that one can use a small amount of money to control a large amount.  If one were to simply buy the shares of a stock and the price increased by 10%, one would make 10%.  If one bought the call options, however, for an equivalent amount of stock, one could make 100%, 200%, or more for the same price move.  It is this type of return that attracts many to options.

In general, however, none of these types of securities is suitable for an
investor.  Investors buy stakes in companies and hold them for long
periods of time – they don’t play short-term price swings.  If one
is looking for a little excitement and the casinos aren’t appealing,
a small amount (say 5% of a portfolio) might be used   for such
speculations.  Plan on losing the entire position, however, since
that is precisely what will often happen.

There are some valid times to use options, however.  Options were designed
to be used as insurance.  By buying a put option on a large amount of
stock, for example, one could put a floor on the price at which the
stock could be sold.  Perhaps if one thought the price was way to
high but wanted to delay the sale into the next year for tax
purposes, one might buy a put option to lock n the gain without
selling and realizing it.  Like all insurance, however, options tend
to cost money and it is more efficient to simply sell the shares to
lock in the gain.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Write Covered Calls, Part 4 – The Reality

To conclude this series on covered call writing, I’d thought I’d offer some pointers from my experience. 

While it is “possible” to make 20-30% per year writing covered calls, I’ve found that the actual returns tend to be far less.  It is easy to look at the 90 day call and imagine yourself collecting that premium every few months, resulting in that 25% return.  There are some issues with this, however.  These are:

1) The bid-ask spread.  As I said in a previous post, the spread – the difference between the bid price and the ask price – for options tends to be large.  When writing a covered call, expect to only get the bid price for the sale.  Likewise, if you need to buy the option back, you’ll pay the ask price.  The option specialist gets to pocket the spread by buying the options from you at the bid and selling it to someone else at the ask. 

While stock price spreads have narrowed considerably since the days when shares were traded in fractions rather than pennies, 1/4 point, 1/2 point, or even larger spreads are fairly common for options.  Given that you’ll only be collecting $1-$2 per option contract, 1/2 of a point will take 25% to 50% of your profit each time you write a call.  For this reason, try your best to not close the transaction – instead allow the calls to expire worthless, rather than covering when the price drops to low values even though it is tempting to write the next set of calls.

2) Commissions and Taxes.  While brokerage fees have fallen quite a bit, often less than 1% on a stock trade, option commissions still tend to be 5-10% of the option sale price.  Likewise, option trades are considered short-term capital gains, and therefore are taxed at regular income levels.  This can carve off another 25%.

3) Market volatility.  Sure, it looks great.  The stock is at $32 per share and you are able to sell 3-month 35 calls for $1.75 each, or a return of $7 per year per share.  But after you write the calls the stock goes up to $36, then $38, then $40.  Your calls, which you sold at $1.75, are now worth $6.50 per share and there is still 1 month to go before it expires.  Because of the increase in price, you need to keep extra cash in your account that is not earning any interest.  

Do you bite the bullet, buy a 35 call, and then write the $40 call, trading at $2.50 per share, to recoup a little of your loss in the option premium?   If you do this, you will have lost $6.50-$1.75-2.50 = $2.25 per share on the option position but would have gained $8 per share due to the stock going up in price, resulting in a net gain of $5.75 per share on the trade.  Remember that you were writing covered calls, however, because you felt the shares were overpriced, and now you are effectively adding $2.25 to the price you paid for them.  If the price falls from $40 per share back to $32, you will now be looking at a loss instead of breaking even.

The opposite can also happen, where the share price falls beyond what you received in premiums, resulting in a loss.  You could then buy back the calls, paying brokerage commissions again, and write a new set at a lower price.  What if the stock then shoots back up, however?  By lowering your strike price, you are lowering the effective price at which you are selling your shares, locking in the loss on the stock.

In general, while covered call writing is tempting, I usually find that I do better just holding shares outright.  If I think a stock has good prospects, limiting my potential gain by selling the gain above some strike price to someone else rarely makes sense.  Likewise, if a stock is overpriced, it is often better to just sell it since the price swings can often easily outstrip any premiums collected from writing calls.  Nevertheless, I sometimes write covered calls anyway to remind myself of why I rarely write covered calls.  It does have some entertainment value, is really good clean fun, and is a lot safer than Vegas. 

This is a continuation of a series of posts on covered call writing.  The series starts here:  http://smallivy.wordpress.com/2011/04/23/how-to-write-covered-calls-part-1-the-background/

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Write Covered Call, Part Three – A Practical Example

Having covered the mechanics of covered call writing and having gone into some of the risks, let’s look at a practical example.

I currently own some shares of BJ’s Restaurants, Incorporated.  The company sells pizza and beer.  They have a series of restaurants out west and sell gourmet pizza and microbrew beer.  I think they have great prospects for the future since they are currently making gobs of money and have a lot of room to expand.  These are key features for which to look  when selecting stocks.

The market has realized their potential, however, and bid the shares up to really high values.  The PE – price to earnings ratio - is over 50.  Many fast growing companies have PE’s in the 30′s, but the 50′s are a bit extreme.  Typically PE will eventually return to a reasonable range, either because earnings increase, or because the price declines.  Because of this, I expect the stock to either sit in the current range for a few years, waiting for earnings to catch up to the price, or the price to drop to a more reasonable level given current earnings.  In any case, the stock is vulnerable to a sharp slide should the company miss earnings, a lawsuit occurs, or some other thing happens like another terrorist attack. 

I don’t really want to sell the shares.  I’ve found that when you sell a great stock, you end up putting the cash in something else and forgetting about the original.  Even if the price falls to reasonable levels or earnings increase, you may not have cash available at the time to take advantage of the lower prices.  For this reason, I’ve written a call option position on the shares.  This will provide some income should the stock sit within a range for a long period of time, and reduce the loss somewhat should the shares fall in price.

When I was ready to write the calls, the shares were trading at about $46.50 per share, having completed a really fast runup the week before.  Looking at the option prices: http://finance.yahoo.com/q/op?s=BJRI&m=2011-07, I saw that the July options have reasonable premiums for the next out-of-the-money options, those with a strike price of $50.  They were selling for about $1.60 per share.  Writing May or June options did not provide enough in the way of premiums.  The later options, like the Octobers, did not offer enough given the long time to expiration. 

If I were more bearish, I might sell the in-the-money options, the July $45s, and collect about $3.80 per share.  If I did so, the price could drop to about $42 per share before I would lose some money.  With the July 50′s, If the price drops below $45 I will lose money from the current value, but I will still make some money if the stock goes up to $50.  Even better, if the stock does not move very far up from the current position between now and July, I’ll get to keep the entire premium from the options and maybe write another set of options.  At $1.60 every three months, this is about $8.00 per year, or an effective “yield” of about 17%.

If the stock stays at current prices or decreases, I’ll just hold the options to expiration.  After that I might continue to write calls as long as the stock is above $40 per share (I think in the $30′s the stock is more reasonable, yet still expensive).  If the stock moves above $50 per share and my shares get sold, I might look at writing covered puts at $45.  In that transaction I would be obligated to buy the shares if they fell below $45 per share. 

As long as I keep the cash in the account for that purchase, it is really like getting the shares below the current price.  I could continue to write puts while the stock price is above $45 until I purchased the shares.  I might even drop the strike price for future options I write if the shares get near $45 per share and continue to lead the shares down until I finally buy them back in the $30′s.  The risk, however, is that the shares may continue to climb and I never get to buy them. 

The shares could also drop well below $45, and then I would be stuck buying them at $45.  Given that I was ready to buy them at a little below $45 anyway, it really was no more risky that putting in an order to buy the shares directly.

In the next post, a summary and some perspective on covered call writing: http://smallivy.wordpress.com/2011/05/05/how-to-write-covered-calls-part-4-the-reality/

This is a continuation of a series of posts on covered call writing.  The series starts here:  http://smallivy.wordpress.com/2011/04/23/how-to-write-covered-calls-part-1-the-background/

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.