pinhi et al:
An example of profiting from a sudden rise in your covered shares, based on today's NTAP prices (numbers slightly rounded). Also an argument for using ATM rather than OTM calls for a covered call strategy. Comments welcome.
Today's prices:
NTAP stock: $95
Sept $55 call: $40 $40 intrinsic, $0 time premium
Sept $85 call: $15 $10 intrinsic, $5 (6%) time premium
Sept $95 call: $9.50 $0 intrinsic, $9.50 (10%) time premium
Sept $105 call: $6
Note the ATM $95 call has the highest premium percent.
Suppose that you own 1000 shares of NTAP, and wrote Sept $95 ATM calls on those 1000 shares today:
Portfolio value today:
$95,000 1,000 shares NTAP
9,500 Cash
--------
104,500
Assuming that NTAP shoots up to $105 tomorrow, then applying the same percentages as today's prices:
Tomorrow's prices:
NTAP stock: $105
Sept $95 call: $16 $10 intrinsic, $6 (6%) time premium
Sept $105 call: $10.50 $0 intrinsic, $10.50 (10%) premium
Tomorrow, you buy back the 95's and roll out to Sept 105's:
$ 9,500 Starting cash
- 16,000 Buy back Sept 95's
----------
- 6,500 Tax loss on Sept 95's
+ 10,500 Cash from writing Sept 105's
----------
4,000 Net cash
Portfolio value tomorrow:
$105,000 1,000 shares NTAP
4,000 Cash
----------
$109,000 Total (plus 2,000 +- gain from tax loss)
If you had not written the covered calls including buyback, but had just held the stock long, your portfolio value would be $105,000 instead of $109,000. So buying back and re-writing on the stock rise can be profitable. Buying back without re-writing would give you a portfolio value of 105,000 + 9,500 - 16,000 = 98,500 (+ gain from tax loss), a losing play.
What you have gained on the stock rise is the difference in premium percentage between ATM and OTM calls. Every stock move in either direction from your ATM call gives you the premium percentage difference - that's why ATM calls work better than others. Using the above NTAP example, every 10% rise in stock value gives you a 14% rise in portfolio value.
And you keep on doing the buybacks with rollups and rollouts until some month rolls around when the current option expires OTM.
The same principles apply to larger jumps from a low value. Note that today's NTAP Sept $55 call price is $40, zero time premium for a 40% OTM call. Let's assume that ELON pays about the same percentages, and your 1,000 shares of ELON stock is down to $25, and you just wrote ATM Sept $25 calls for $2.50 . The stock jumps up to $40, a 60% jump in value, which puts your $25 calls 40% OTM.
You don't want to let the stock get called away at that $25 price.
At ELON $40, the $25 calls are worth $15 (remember far OTM = zero time premium), and $40 ATM calls are worth $4 (10%). Your portfolio is now worth $40,000 plus $2,500 cash. You buy back the $25 calls (minus $15,000), and you write the $40 calls (plus $4,000), giving you a portfolio value of $42,500 - 15,000 + 4,000 = 31,500, versus $27,500 if you allow the stock to be called. You still own the stock (though you might have to sell about 20% of the $40 shares to cover the buyback), you're $4,000 ahead in portfolio value, and you have a $12,500 tax loss (worth $3,000 to $5,000 at tax time).
In this case, you're $8,500 worse off than if you had just held the stock long, but $4,000 better off than if you just let the stock be called out at $25. If you count in the tax loss, the buyback case is only $4,500 or so worse than uncovered holding long.
Buying back without rewriting would leave you with $42,500 - 15,000 = 27,500, the same as letting yourself be called out, plus you have a 12,500 tax loss. You would need to sell about 30% of your $40 shares to cover the buyback.
Lesson: Try not to write calls in the depths of a correction unless you can watch the market closely enough to buyback and re-write every (hopefully) 10% or 15% or so of the recovery.
Lesson: If you do get caught writing a call at the bottom and you don't take any action until the stock has jumped way up, then buyback and rollout as described above is a lot better than letting the stock be called away.
Lesson: As Voltaire says, choose stocks that you would want to own for the long term. Good stocks come back from corrections, other stocks ofttimes do not.
Watch out for practical details, like the premium percentages for ATM and OTM calls for different stocks, the percentage bid/ask spread on a stock's options, the liquidity of a stock's options market (can you buy and sell easily at the same time), the degree to which a stock's call options are under/overpriced when the stock is dropping/rising, and the tax implications of allowing your stock to be called. Also, spending every call premium you get is like spending all your paycheck each week - come bad times, you're in trouble.
The above examples show profiting from premium percentage reduction as your calls move from ATM to OTM. Additionally, not shown above, the premium percentage is constantly eroding as expiration time approaches, another factor in your favor.
Hope this is useful, and that I got the arithmetic right :-)
- Dwayanu
Voluntary Disclosure: The above is all theoretical. Execution requires some degree of comfort and experience with, and attention to, the market. YMMV :-) |
