Price Appreciation Benefits for Calls
In this case, you can afford to write calls with striking prices above your original basis, even if they are in the money; or you can write out-of-the-money calls as long as time value is high enough.
ExamplePrice Appreciation: You bought 100 shares of stock last year when the value was $27 per share. Today, the stock is worth $38.
- Write a call with a striking price of 25. The premium will include 13 points of intrinsic value plus time value, which will be higher for longer-out calls. If the call is exercised you lose two points in the stock, but gain 13 points in the call, for an overall profit of $1,100. If the stock's market value falls before exercise, or when time value disappears, you can cancel with a purchase and profit on the option trade, which frees you up to write another call. Any decline in stock market value is offset dollar-for-dollar by call profit in this case. The change in capital gain status and consequential tax liability on the stock should also be factored in to this calculation.
- Write a call with a striking price of 30. In this case, intrinsic value is 8 points, and you can apply the same strategies as in number 1, above. However, because your position is not as deep in the money, chances for early exercise are reduced somewhat; in the event of exercise, you would keep the entire option premium, plus gaining $300 in profit on the stock.
- Write a call with a striking price of 35. With only 3 points in the money, chances for early exercise are considerably lower than in the first two cases. Any decline in the stock's market value will be matched point for point by a decline in the call's intrinsic value, protecting your stock investment position. Because this call's striking price is close to current market value, there may be more time value than in the other alternatives.
- Write a call with a striking price of 40 or 45. Since both of these are out of the money, the entire premium represents time value. The premium level will be lower since there is no intrinsic value; but the strategy provides you with three distinct advantages. First, it will be easier for you to cancel this position at a profit because time value will decline even if the stock's market value rises. Second, if the option is eventually exercised, you will gain a profit in the option and in the stock. Third, your long-term capital gain status in the stock will not be lost because the call is out of the money.
If you own stock with an appreciated market value, you face a dilemma that every stockholder has to resolve. If you sell and take a profit now, that is a sure thing, but you lose out in the event that further profits could also be earned by keeping those shares. You also face the risk of a decline in market value, meaning some of today's appreciated value will be lost. As a long-term investor, you may be less concerned with short-term price changes; however, anyone would like to protect their paper profits.
Covered call writing is the best way to maximize your profits while providing downside protection. As long as your call is in the money, every point lost in the stock is matched by a lost point in the call; a paper loss in the stock is replaced with profits in the call position. The time value premium is potentially all profit, since it will disappear even if the stock's market value goes up, an important point that too many options traders overlook (especially buyers). When your basis is far below striking price of the call, you lock in a capital gain in the event of exercise.
Smart Investor TipTime value declines over time, even when the stocks's market value goes up. This is a problem for buyers, but a great advantage for sellers.
In this example, you gain two levels of downside protection. First, the original basis is protected to the extent of the call premium; second, paper profits in the current market value also gain downside protection. When stock has appreciated beyond its original cost, it makes sense to protect current value levels, and call writing is a sensible alternative to selling shares you would not otherwise want to give up. You would probably view a decline in market value as a loss off the stock's high, even when the current stock price remains above your original cost. Call writing solves that dilemma.
ExampleDiscounted Basis: You bought 100 shares of stock several years ago at $28 per share. Today it is worth $45. You sell a 45 call with four months to go until expiration. The premium was 4, all of which is time value. This discounts your original basis down to $24. If the stock were to fall 4 points or less, the call premium protects the paper profit based on current stock price. If the market value rises and the call is exercised, your shares would be called away at $45 per share, a profit of $2,100 ($1,700 on the stock plus $400 on the call).
By Michael C. Thomsett