Strategies

 

What is the risk in selling a covered call at a strike price considerably higher than the stock price at the time I wrote the call? It seems that the only risk is less profit if the call is exercised.

Whenever you write a covered call, first ensure that you would be happy to lose the stock at the net effective sale price (NESP = call strike price plus call premium). If NESP does not provide the anticipated profit when you first acquired the stock, you probably should not write the call. Writing a far out-of-the-money call (or, as you stated, a “call at a strike price considerably higher than the stock price") may offer very little premium. Ask yourself if the net premium, after the transaction costs, is enough to justify the transaction.

A ground rule employed by many covered call writers is that the potential return, if the stock is called, should be about twice the risk-free (Treasury bill) rate. As an example, if a 60-day Treasury yields 5% per annum, a two-month covered call write should produce an annualized 10% return.

This guideline also states that the return created by the covered write should equal at least the risk-rate if the stock remains static. Another guideline regarding premium is that the downside protection gained by call writing should equal at least 3% of the stock's current market price. There is also the risk that the stock could drop significantly, or to zero.

 

 

Generally, if someone purchases and sells the same call, it's likely that the two transactions match as opening and closing transactions and eliminate the position. While not common, there may be some strategies where an investor wishes to remain long and short on the same contract. This eliminates the naked margin but the position still bears the risk of assignment on the short call option.

 

 

Generally, if you simultaneously buy options and sell the same number of options within the same series, you have a flat position in that option series. If you conduct the trades in different accounts or with different brokers, you do not offset the positions within the same account. However, since you would be simultaneously long and short the same asset, you are still flat from an economic point of view. Your total position nets to zero.

Whether you conduct the purchase and sale simultaneously, or at different times, your total position is a net long, net short or flat position.

Financially, if you concurrently conducted the transactions, you would be buying at the ask price and selling at the bid price, immediately placing you at a net loss due to the bid-ask spread. If you placed an order to buy and sell the same security at the same time, conducting both sides of the transaction with yourself, regulators consider this a wash sale, because there is no change of beneficial ownership. This is a violation of various rules and regulations.

In summary, there is little or no advantage to being both long and short the exact same option. The two positions net to zero. There could potentially be a violation of exchange rules. Last, there is probably more cost than benefit due to commissions coupled with bid-ask spreads.

 

 

Can I perform a spread by purchasing an at-the-money LEAPS® call and selling a front month out-of-the-money call?

Yes, you are describing the diagonal call spread strategy. When considering implementing this strategy, be aware of the risks and (potential) rewards.

In the worst-case scenario, if you are assigned on the front month call and then exercise your LEAPS® to cover the assignment, your loss is the net debit paid to establish the position, less the difference between the strike prices of the two options.

It’s more difficult to establish a maximum gain for this strategy, which resembles the covered call. The best-case scenario is for the stock to go sideways or gradually rise over the life of the LEAPS® call, allowing you to roll out your front-month option every month at a credit.

Review the various LEAPS® strategies including spreads, in the LEAPS® section.

 

 

How can I take advantage of discrepancies in options pricing between puts and calls and among the different expirations. Sometimes front months trade at much higher volatility levels and at other times, the higher volatility is in the back months. How long do these discrepancies exist, and where can I learn more?

There are different levels of volatility and costs of carry for puts and calls and for different strikes and expirations. However, this complexity is not artificial. It reflects actual differences in the factors that influence an option's price.

For example, the industry bases most options pricing models on the normal distribution function. Stocks tend to deviate slightly from the normal model and traders compensate by tweaking the volatilities (skew) that they input into their model. In the case of puts and calls, the cost of carry tends to push calls to a premium and puts to a discount. The early-exercise feature prevents puts from falling below their intrinsic value. This distorts the put-call parity that exists for European-style options.

Traders take positions that benefit from changes in cost of carry, volatility skew, etc. It's very difficult to calibrate such positions and it generally requires making several trades. These types of strategies are usually only suitable for full-time investors who have very low marginal trading costs (but often have high fixed costs, such as exchange memberships).

 

 

What is the difference between a call and a put? Why does my broker tell me that I can't sell a put when I'm long the stock?

An equity option is a contract.

The call contract conveys to its holder the right, but not the obligation, to buy shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day).

The put contract conveys to its holder the right, but not the obligation, to sell shares of the underlying security at the strike price on or before a given date (expiration day).

After this given expiration date, the option contract ceases to exist. If assigned, the seller of an option is obligated to sell (in the case a call) or buy (in the case of a put) the shares at the specified price.

In a covered call, the investor sells a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If an investor is assigned an exercise notice on the written contract, they sell an equivalent number of shares at the call's strike price.

Your broker might have concerns about selling a put option while long the underlying stock. If the investor is assigned an exercise notice on the written contract, they buy an equivalent number of shares at the put's strike price, effectively getting longer the underlying stock.

For more strategy related questions, visit our Strategies & Advanced Concepts section.

 

 

Do I need to hold my option until expiration after it turns profitable? If my option has increased in value but still has time value, is it a bad idea to close the position and collect a profit?

In general, whether or not to hold a profitable position depends on your outlook for the underlying stock and your risk/reward preference. If you think that the stock has experienced most or its entire anticipated move, you might want to close out your position and take the profit. If you think the underlying stock has a lot further to go, for even more profit, you might want to let your profits ride (and take the risk of a reversal in stock direction). Moreover, if you think the stock has further to go but want to reduce the amount of your investment, you might want to sell your options, or a portion of the position. You might even consider then buying options with a more distant strike, thereby earning a credit on the spread.

 

 

It is an advantage to know what the risks and rewards are for that position. The vertical spread consists of buying one option and selling another with a different strike but both expiring in the same month.

Another advantage of a vertical spread versus a single option position is that it is possible to put a cap on the amount of risk the option writer (seller) assumes, and decrease the costs of the purchase if you are an option buyer.

One obvious disadvantage is that while limiting risk, the investor also limits their profit. Therefore, the investor caps profit potential. In addition, commissions and interest charges could affect the profitability of all spread strategies. Consult a tax advisor concerning the tax consequences of any spread strategy.

There are occasions where certain types of corporate actions may affect the profit/loss profile of a spread. Extraordinary dividends, tender offers and even mergers can alter the dynamics of a spread.

 

 

If I buy an in-the-money LEAPS® call and sell a shorter-term call against it, which is just out-of-the-money, what happens if I am called? How do I settle the trade? Do I have to exercise the in-the-money LEAPS® call to get the stock and then deliver the stock to the party that exercised the option that I sold? Is there an alternate way to settle the trade?

One of the risks in entering into a calendar spread position is the early assignment on the short leg of the spread. Therefore, the registered options principal (ROP) of your brokerage firm will need to approve you for uncovered options transactions. The near-term, at-the-money or just out-of-the-money options with higher premiums are tantalizing, but have added risk as those contracts, for the moment, have a better chance of finishing in-the-money.

How will you meet your obligation(s) to deliver the called stock? If it's your plan, if called, to exercise your long LEAPS® position, you should carefully review the strike prices of the contracts in the spread to give yourself a chance that if called, you still have a profit. Remember, when you exercise an option contract, you forgo any time value. You should understand in advance the rules for handling option assignments using this type of strategy. In most cases, if you are assigned on a short option position, you must take some sort of action (e.g., exercise your long call, buy stock in the open market) to meet your stock delivery obligations.

In the event of assignment, if an investor chooses to exercise their LEAPS® call, because of the one-day lag between exercise and assignment, using the long-term call to close out the position requires being short the stock for a day. Discuss this strategy with your brokerage firm.

 

 

I've read some options books where experienced and successful traders described a strategy of buying 'cheap' options and selling 'expensive' options. How can one go about determining whether or not an option is 'cheap' or 'expensive' and indeed, what does it mean?

Advanced traders consider options cheap or expensive according to the level of their implied volatility relative to the historic or predicted volatility.

However, it's a little more complicated than that, because you can divide option strategies into either directional strategies and/or volatility strategies. It might not do much good to buy a cheap call option, for example, if the underlying company ended up in bankruptcy. Cheap is also a relative term. Remember that all out-of-the-money options at expiration are worthless.

In addition, there may be a reason that the market is pricing the option more inexpensively than in the past. If it is cheap today and cheaper tomorrow, then what's going to happen the next day? Predictions are merely speculation. They may have a sound theory to them, but may not prove to come true.

OIC offers online Options Calculator to assist in calculating implied volatility.

 

 

Is it true that a buy-write (i.e., buying stock and simultaneously writing a call option against that stock position) and selling a put are equivalent?

Some advanced traders and investors sometimes refer to a covered call (buy long stock and short a call) as a synthetic short put. The risk/reward profile of a covered call position is almost identical to a true short put. To review the risk/reward profiles for these (and other) strategies, view the Strategies section of the OIC website. 

 

 

We offer an explanation in Understanding Profit and Loss Graphs.

 

 

A long straddle is a combination of buying a call and buying a put on the same underlying security, both with the same strike price and expiration. Together, they produce a position that should profit if the stock makes a big move either up or down. Typically, investors buy the straddle because they predict a big price move and/or a great deal of volatility in the near future.

For instance, an investor might consider a straddle when an earnings announcement is forthcoming, resulting in large price swings in the underlying in either direction. Since the straddle involves two premiums, for the position to be profitable, the move needs a corresponding option price increase that covers the two premiums paid for the position.

To learn more about straddles or other strategies, you might visit the Strategy section.

 

 

The long strangle is the simultaneous purchase of a long call and a long put on the same underlying security with both options having the same expiration, but where the put strike price is lower than the call strike price. This strategy may be beneficial when the investor feels large price movement, either up or down, is about to happen, but is uncertain of the direction.

For instance, an investor might consider a strangle when an earnings announcement is forthcoming, resulting in large price swings in the underlying in either direction. Since the strangle involves two premiums, for the position to be profitable, the move needs a corresponding option price increase that covers the two premiums paid for the position.

To learn more about strangles or other strategies, you might visit the Strategy section.