Fundamentals Generate Income,Trade Options Like a Pro |
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Covered Call
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Covered call option strategy description: |
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This strategy is suitable for those who hold an underlying security and their outlook for the short term is neutral. It is suitable for those who want to sell their underlying security at a premium, and is suitable to hedge the underlying security position from a moderate decline. The procedure is to acquire the underlying security and then write (selling short) an underlying call option. The gain mostly will come from the option that would lose value through time decay, and eventually if it not assigned, it will be worthless at expiration (out-of-the-money). Before entering a trade, please check the account requirement and restrictions (see the following note). Prospect direction: The stock will be neutral to slightly bullish, considering the duration advantage and implied volatility disadvantage (if the financial instrument declines, normally IV will increase). Profit potential: At expiration, contracts premium. Loss potential: Since this strategy holds long underlying security and since it can deteriorate its value to zero, then it means that maximum loss could be the premium received deducted from total underlying cost. Risk reward: Premium received, divided by the probable loss. Breakeven points = starting stock price - premium (expiration date), assuming the stock and option positions were executed simultaneously. Time factor: All other variables stay unchanged, as with most short-option strategies, the passage of time has a positive impact on the short seller. As time remaining to expiration decreases the statistical chances for a loss in intrinsic value shrinks, too. Implied volatility: An increase in implied volatility would negatively affect this strategy, all other variables being equal. Volatility tends to boost the value of options, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower options value, regardless of the stock price trend. Dividends: The dividend has a minimal affect on covered call strategy. On an ex-dividend date, the amount of the dividend will deduct from the value of the underlying stock and on the other hand, the short call option value will decline, not with the same amount as with the underlying security, because for every contract that represents 100 stocks (100 deltas) its delta value is most likely less than 100 deltas. Assignment: There is a chance that the option contract holder will assign his contract before expiration because option contract holder has up until the expiration day the right to assign his in-the-money contract, or the contract will settle with cash. Assignment is sometimes in favor of the contract writer and the reason is that pre-concession of contracts holder on the remaining time value to expiration. On the other hand, sometimes assignment is not in favor because of its dependency on fees and slippage. Assignment process: As the assignment notice arrives to the clearinghouse, settlement price sets on the assignment day's closing price. At this price the contract writer will sell the underlying security, and then the clearinghouse will position the contract owner by the same amount and price, long underlying securities. The next day the writer will be in a short underlying position and the contracts owner will be in a long position. Mark-to-Market Profit and Loss • Contract owner’s account after the assignment: '10 X 100 X 47' (100 deltas or number of stocks for every contract). If prior to the assignment the account was long 1,000 underlying securities, then the account will be with null position and a remaining cash of $2,000, or the account position is long 1,000 underlying securities. If the contract holder does not wish to be in the long position or does not have sufficient margin funds, then the contract owner must sell the underlying securities back in the market. At this point, the contract owner is exposed to market price fluctuations. • Contract writer account after the assignment: '10 X 100 X 45' (100 deltas or number of stocks for every contract). If prior to the assignment the account was long 1,000 underlying securities, then the account will be in a null position and short cash of $2,000, or the account position is short 1,000 underlying securities. If the contract holder does not wish to be in the short position or does not have sufficient margin funds, then the contract owner must buy the underlying securities back in the market. At this point, the contract writer is exposed to market price fluctuations. Note A common brokerage firm calculates short-selling risks according to the financial instrument’s probable volatility, called standardized stress of the underlying. For instance, for equity options, narrow based indices, single stock futures, and mutual funds the stress parameter is plus 15%, minus 15% and add the premium received. To illustrate a short put’s required funds, let's take for example writing one put, strike $50.00, stock price at $48.00, 45 days to expiration. The calculation will be as follows: the risk is on the downside, 52 X 0.85 = 40.80. Then 50 - 40.8 = 9.2 premium received 3.1, meaning the account must have funds exceeding 9.2 + 3.1 = 12.3 for every contract (more than three times the premium). The broker monitors margin requirements in real time and will liquidate the account 10 minutes after the margin call, if there is no response fixing the margin requirements. However, a covered call position holds the required underlying to cover a rally that supposes to incur damage to the short option strategy. Also, instead of buying the stock, it is sometimes better to buy the futures contract. |
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