Timing the Options Call Decision
Exercise can occur at any time that your call is in the money. It is more likely to occur close to expiration date, but you need to be prepared to give up 100 shares of stock at any time the short option remains open. This is the contractual agreement you enter when you sell the call.
Smart Investor TipWhenever you sell a covered call, be prepared for exercise at any time when the call is in the money. The covered call strategy makes sense only if you are willing to have your 100 shares called away.
- When the striking price of the call is higher than the original price you paid for the stock, exercise is not a negative; it automatically triggers a triple profit -- from appreciation of the stock, call premium, and dividend income.
- If you sell a call for a striking price below your original cost of stock, be sure the premium you receive is greater than the loss you will experience in the stock in the event of exercise.
[caption id="attachment_12492" align="aligncenter" width="360"] Timing of call transactions
relative to price movement of underlying stock.[/caption]
- In calculating potential yields, be sure to allow for trading costs on both stock and option, and for both entering and leaving the positions.
- For the benefit of producing a consistent profit from writing calls, remember that you give up the potential for greater gains if and when the stock's current market value rises.
- The tax consequences of covered call writing have to be included in your calculation, especially if you have a substantial paper gain in the stock and have owned that stock long enough that gains would be long term. In instances when you write in-the-money calls against stock, you could lose the long-term status of stock, so tax planning has to be a part of your strategy unless you restrict your short positions to out-of-the-money contracts.
ExampleAlternative to Selling: You buy 100 shares of stock at $51 per share, and it rises to $53. Rather than sell the stock, you choose to sell a call with a striking price of 50, and you are paid a premium of 7.
- If the stock's current market value falls below your purchase price, you can buy the option and close the position at a profit, or wait for it to expire worthless.
- By selling the call, you discount your basis in the stock from $51 to $44 per share, providing yourself with 7 points of downside protection. In the event of a price decline in the stock's market value, this is a substantial degree of protection.
- You continue to receive dividends as long as the option is not exercised.
ExampleGoing Deep: You bought stock at $51 per share and it is now worth $53. You will receive a premium of at least 8 if you sell a call with a striking price of 45 (because there would be 8 points of intrinsic value). That also increases the chances of exercise substantially. For the 8 points in intrinsic premium, you would lose 6 points in the stock upon exercise (your original basis of $51 less exercise price of $45). These outcomes would change if time value were also available. For example, a 45 call might have current premium of 11, with the additional 3 points representing time value. Upon exercise, the additional 3 points would represent additional profit: $1,100 for selling the call, minus a loss of $600 on the stock, for a net profit of $500 upon exercise. The tax consequences have to be calculated as well. A long-term gain could be subject to short-term treatment for writing deep-in-the-money calls.
Smart Investor TipSelling deep-in-the-money calls can produce high profits for call sellers, especially if they want to sell their stock anyway.
ExampleExercise or Fast Profits: You bought shares of stock at $51 per share, and it is worth $53 at the time that you sell a 45 call. You receive a premium of 11. The market value of the stock later falls three points, to $50 per share. The call is worth 7, representing a drop of three points of intrinsic value and one point of time value. You can close the position and buy the call for 7, realizing a $400 profit. You still own the stock and are free to sell covered calls again.
- The original price per share of the stock.
- The premium you will be paid for selling the call.
- The mix between intrinsic value and time value.
- The gap between current market value of the stock and striking price of the call.
- The time until expiration.
- Total return if the call is exercised, compared to total return if the option expires worthless.
- Your objective in owning the stock (long-term growth, for example), compared to your objective in selling the call (immediate income and downside protection, for example).