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Options 102 – Covered Calls and Puts

In our last article – ‘Options 101’ – we focused on basics of buying puts and calls.  In this article, we discuss selling calls and puts – the staple strategy here at In the Money

There are two basic strategies for selling calls and puts:  Covered and naked.  Each has advantages and disadvantages, and just like the beach – most people want to remain covered, but some just enjoy being naked.

COVERED CALL STRATEGY

This involves selling call options on a security that you already own – although many brokerages allow a simultaneous transaction (buying the shares and selling calls in the same trade).

By selling the call option, you are agreeing to sell your shares – known as the underlying asset – at the strike price of the call option for a fixed time period (until the expiration date).  In our META example from Options 101, with META shares trading at $170, the call option expiring one week later was trading at $3.60.

In a covered call trade, we would buy the shares (in 100 share lots) and sell the option, taking in $3.60.  That money is our to keep – no matter what.

If META trades above $170 a week later – even if it runs to $250 – we have the obligation to sell the shares at $170.  We would be disappointed – missing a massive $80 rally – but we would still earn a 2.12% return for the week because we keep the options premium.

Conversely, if META shares traded down $2 to $168, we would lose $2 on our long position – just like everyone else who is long the shares – but we would make money ($1.60 per share, if you are keeping score).  Why?  We keep the $3.60 we received for selling the call option.  The covered call strategy effectively caps your upside, but it eases – but doesn’t eliminate – the downside.

COVERED PUT STRATEGY

This involves selling put options on a security you are short. Like the covered call, you take in the premium and it’s yours to keep.

It doesn’t matter if the put option gets exercised or not.  Unlike the calls, however, the purchaser of the option has the right – but not the obligation – to force you to buy shares of the underlying stock at the strike price.  If you sell META $170 puts, you could be required to buy META shares at $170.  It wouldn’t matter if the shares are trading at $165 or even $120.  You will buy them for $170.  Of course, if META is trading above the $170 strike price at the option expiration date the holder of the option would not exercise their right.

When the option holder does not exercise their option:

  1. With covered calls, you are left with the underlying security
  2. With covered puts, you are left short the underlying security

Come Monday morning, the options you sold disappear from your account and the long portion (if you wrote covered calls) or the short position (if you wrote covered puts) is still there.

You then have a choice

  1. close the position,
  2. write new options against the position or
  3. keep the position open without any options written against it.

Why does this decision (almost always) come on Monday morning after options expiration?  In most cases, the option holder will not exercise their right to buy your shares until the day the option expires (and usually in the last hour of the day).

Not only does this preserve their capital (options are usually much less expensive than the underlying shares), but an option holder can never lose more than the premium they paid to purchase the options while a stock holder can lose $10, $20 or more per share on a particularly bad day.  Why exercise the option early and take on this risk?!?!

WHEN TO USE COVERED PUTS AND CALLS

There are three primary strategies for utilizing covered calls and puts:

  1.  ‘Income’ or ‘at the money’ strategies,
  2. limit order’ strategies and
  3. ‘In the Money’ strategies.

‘Income’ options strategies generally involve writing covered calls in order to receive extra income on a stock.

I’M SORRY I SCREWED THIS UP – BUT THIS HAS TO BE EVERGREEN COPY—NOT HAVE TO CHANGE IT FOR A COUPLE MONTHS—THIS EXAMPLE TIME DATES IT—AND LET’S USE EVEN DOLLAR #S WHEREVER POSSIBLE TO

A simple example would be to buy units (it is an MLP; a pipeline company) of Energy Transfer (ET-NYSE) at a theoretical $13.00 and write  calls for a HOW MANY MONTHS out with a strike price of $13.  Those calls cost $.93.

If we believe it is likely Energy Transfer shares will still be trading around $13.00 a month out, it is pretty likely the shares will be taken away.  We would realize a flat trade (we bought and sold them for $13.00; the strike of the call option we sold is $13.00 – giving the buyer to buy our shares from us at $13.00).

But…  We keep the $.93 option premium.

In this scenario, we would realize a $.93 gain on the covered call trade in eight months – or 7.00%. 

Energy Transfer is also a dividend payer, with a 9.4% yield.  If we hold the units until October 20th – which we almost certainly would given options holders almost always exercise options on expiration date – we would collect two $.305 per unit dividends, or $.61.  In the scenario where Energy Transfer is trading at or just over $13.00 in October, our total gain would be $1.52 per unit – or 11.7% in eight months.

There are a couple more benefits of income strategies as well.  Instead of rooting for your long positions to go up in price, you wake up each day and check the quote hoping it is flat.

Suddenly unchanged is great.

Remember, you get zero benefit if the shares go up – you have effectively agreed to sell them at $13? no matter what.  Energy Transfer goes to $20?  You’ll get $13.  So flat is good!

The other benefit is that you get downside protection.  If Energy Transfer units fall 10% by October – to $11.72 – someone with just a long position (obviously) loses 10% on the shares – or $1.30 – which would be partially offset by the $.61 of total dividends they should receive (making their loss $.69 per share, or 5.3%).

In our $13 covered call example, however, the covered call writer still makes a profit:  Despite losing $1.30 on the Energy Transfer long position, the covered call writer took in the $.93 option premium and $.61 in dividends ($1.54 total) resulting in a $.24 gain – or 1.8%.

So with our trading strategy, you can be right (a profitable trade!), even when you’re wrong.

This is a very important concept:  Every covered call or covered put position has a breakeven price – the price where the overall trade starts to lose money.  You should always know your breakeven before opening a covered call or put position.

INCOME STRATEGIES WITH PUTS

While the idea of ‘income’ on a short position seems strange, covered put strategies allow options premiums to be earned on short positions.  Because those short stocks pay out dividend rather than receive them, one primary difference between covered call income strategies and covered put income strategies is that dividends are your friend if you are writing covered calls while they are your enemy (and expense!) if you are writing covered puts.

The second of our three primary covered call and covered put strategies – which we call the ‘limit order’ strategy (this is not a common industry term) – involves selling options at strikes and expirations where you would actually want to exit your position.

Let’s say, for example, we own and love Energy Transfer shares and are convinced they are going to $17.00 this year (remember the stock is theoretically trading at $13), at which point they would arguably be fairly valued .

Some investors will actually put out limit orders at their price target to maintain discipline – HUGE mistake!  Why not sell the October $17.00 call (for $.07) or the January, 2024 $17.00 call (for $.26) and effectively get paid for putting a (kinda sorta) ‘limit order’ out there via the options market that lets your shares be taken at that price?

While you may yawn at an extra percentage point or two in this example (pennies count!), on a more volatile stock like META the October $200 strike calls are trading at $19.70 with META shares trading at $183.12.  That’s a heck of a big payment for a ‘limit order’ if you truly plan to sell at $200. AGAIN ALL THESE EXAMPLES NEED TO BE GREENFIELD AND USE ROUND NUMBERS AS MUCH AS POSSIBLE.

The third of our three primary covered call and covered put strategies involves writing ‘In the Money’ options on long or short positions.  While these strategies tend to provide very limited upside potential, they add a significant amount of certainty, especially for shorter term options.

Sticking with our Energy Transfer example, an investor could buy ET units at $13.02 and immediately write April, $11 call options for $2.15.  As long as Energy Transfer is trading above $11.00 in six weeks –– this ‘In the Money’ trade would result in a $.13 profit, or 1.0%.  While this is a lower return than we generally seek for ‘In the Money’ trades, it would result in a 12.2% annualized return without using margin.

Keep in mind, even an ‘In the Money’ trade can lose money, but our breakeven point on our Energy Transfer example would be $10.87 per share (the $13.02 purchase price minus the $2.15 call option premium) – 19.8% below the current price.

Over the fifty months since the beginning of 2019, Energy Transfer shares have declined more than 19.8% over the course of a month twice:  A 20.0% decline in December, 2019 and a whopping 59.1% decline in March, 2020 as the pandemic hit.

FINAL LESSON

This brings us to our final lesson for ‘Options 102:’   Any covered call or covered put trade can be closed out early if the position looks likely to result in a loss.  The option written against the long or short position can be repurchased in the open market (you don’t need to buy it back from whoever bought it from you – in fact you will never know who purchased it) and the underlying position can be  closed.

In summary, even deep ‘In the Money’ strategies require investors to have a market view (do you write call or puts?) and a fundamental view on the positions being traded.  If only there were a monthly service run by two experts with more than fifty years of combined market experience who follow and model stocks every day to guide investors through the process….

Nathan Weiss & Keith Schaefer
Co-Founders, In The Money options trading service
Questions or comments? Reach out to us by email at: help@inthemoney.capital

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