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 Tip

Whenever 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.

As shown in Figure , during the life of a call, the underlying stock might swing several points above or below striking price.
If you own 100 shares and are thinking of selling a covered call, keep these points in mind:

Example

Alternative 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.

In this example, the premium contains only 3 points of intrinsic value. The 4 points of time value indicates the probability of a long time to go to expiration. Selling a call in this case provides several advantages to you:You can also choose to sell a covered call that is deep in the money, as long as you are aware of the tax consequences of that decision.

Example

Going 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 Tip

Selling deep-in-the-money calls can produce high profits for call sellers, especially if they want to sell their stock anyway.

This is not an unreasonable method for producing profits. The outcome occurs only if the call is exercised; in the event the stock's market value falls, the call premium falls one dollar for each dollar lost in the stock's market value. You can buy the call to close the position, with the profit discounting your basis in the stock. Once the position has been closed at a profit, you can repeat the strategy, further reducing your basis in the stock. There is no limit as to how many times you can sell covered calls after a closing purchase, or after expiration.

Example

Exercise 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.

Always select options and time covered call sales with these considerations in mind:
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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