Explaining the Covered Call
Why did I do this? I see a lot of volatility and that is translating into premium pricing on calls.
There are 3 possible scenarios: stock advances, stays flat or declines.
I paid $3.75 and then rented out these shares for $0.40. The renter has until May to buy my shares at $4.
First of all, that's 11% for a 7 week period - an enormous rate for such a short time.
This is due to the implicit volatility and the market's expectation that >$4 is very, very likely. In fact, it hit $4.20 last week.
Let's assume that it is option expiration day:
Scenario #1: ETFC >$4
The call will be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%
Scenario #2: ETFC $3.40~$4
The call is unexercised. I still have the stock and my cost basis is $3.35 ($3.75-$0.40). I am ahead and can write another call or sell or hold.
I am protected at least 11% downside by the $0.40 I received for the call.
Scenario #3: ETFC <$3.35 The call is unexercised. I still have the stock and my cost basis is $3.35. I am at a loss, but I can write another call and further reduce my cost basis. So in 2 of 3 scenarios I am ahead. In the 3rd scenario, I am down. The stock hasn't closed below $3 in 10 weeks, which is saying a lot. But it did see $2.25 in early January. The trick is in choosing a stock that I feel is trending up, not down. 1. Business is up since January and they have an additional $1B in assets 2. They dumped their mortgage exposure last quarter 3. The recent Fed moves will lower investment companies costs while raising their profits. 4. ETFC is down 90% from June when they were $25 5. They are still profitable (ignoring the write-offs last quarter) So what might occur between now and May expiration? Lets say it is April 30th. Scenario #1: ETFC >$4
The call will most likely be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%.
I could buy bcak the call, but I'll be paying more than $0.40. I would do this only if I thought that ETFC was about to zoom higher. Possibly a merger with TD Ameritrade. In that case, I would be trading the likelihood of an 18% gain in 7 weeks for some hoped-for higher return
Scenario #2: ETFC $3.40~$4
Anything is possible. I could buy the call back (close it out) and probably pay much less than I earned because options erode in value over time.
For example, if ETFC is $3.75, I would estimate that the May $4 call would be ~$0.25. So I could close out the call and sell the stock and net $0.15 or 4% in 1 month.
Scenario #3: ETFC <$3.35 Anything is possible, but the stock is clearly breaking down and re-visiting short term lows. After all, that is at least 11% below my purchase price and 25% below it's recent high. In any case, the $4 May call is probably super cheap: ~$.10. If i think the stock could crash further, I could sell the stock, I could close the call option and sell the stock, or I could close just the option and assume that this was a short term drop and that the stock will rise again. The key assumption here is that the stock isn't going down more than 15%~20% for any length of time. That is a VERY dangerous assumption and very risky. I am mitigating that risk (I hope) by carefully choosing a stock that seems to have bottomed. One last thing, I am deliberately writing short-term calls: 1 or 2 months at most. This gives me a good return while also retaining some flexibility. I actually hope for 1 of the following 2 scenarios: 1. ETFC >$4 in May. Lock in 18% in 7 weeks.
2. ETFC $3.35~$4. I would write another set of contracts, hopefully also for 11%.
My hope is that eventually the options are exercised and someone takes my stock. But not after I yield 11%+ a few times.
If I do this twice and drop my cost basis to ~$3 and then sell >$4, that's a nice 33% return.
There are 3 possible scenarios: stock advances, stays flat or declines.
I paid $3.75 and then rented out these shares for $0.40. The renter has until May to buy my shares at $4.
First of all, that's 11% for a 7 week period - an enormous rate for such a short time.
This is due to the implicit volatility and the market's expectation that >$4 is very, very likely. In fact, it hit $4.20 last week.
Let's assume that it is option expiration day:
Scenario #1: ETFC >$4
The call will be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%
Scenario #2: ETFC $3.40~$4
The call is unexercised. I still have the stock and my cost basis is $3.35 ($3.75-$0.40). I am ahead and can write another call or sell or hold.
I am protected at least 11% downside by the $0.40 I received for the call.
Scenario #3: ETFC <$3.35 The call is unexercised. I still have the stock and my cost basis is $3.35. I am at a loss, but I can write another call and further reduce my cost basis. So in 2 of 3 scenarios I am ahead. In the 3rd scenario, I am down. The stock hasn't closed below $3 in 10 weeks, which is saying a lot. But it did see $2.25 in early January. The trick is in choosing a stock that I feel is trending up, not down. 1. Business is up since January and they have an additional $1B in assets 2. They dumped their mortgage exposure last quarter 3. The recent Fed moves will lower investment companies costs while raising their profits. 4. ETFC is down 90% from June when they were $25 5. They are still profitable (ignoring the write-offs last quarter) So what might occur between now and May expiration? Lets say it is April 30th. Scenario #1: ETFC >$4
The call will most likely be exercised and I will get paid $4. That is $0.25 gain on the stock and $0.40 on the call. Total gain = $0.65 or 18%.
I could buy bcak the call, but I'll be paying more than $0.40. I would do this only if I thought that ETFC was about to zoom higher. Possibly a merger with TD Ameritrade. In that case, I would be trading the likelihood of an 18% gain in 7 weeks for some hoped-for higher return
Scenario #2: ETFC $3.40~$4
Anything is possible. I could buy the call back (close it out) and probably pay much less than I earned because options erode in value over time.
For example, if ETFC is $3.75, I would estimate that the May $4 call would be ~$0.25. So I could close out the call and sell the stock and net $0.15 or 4% in 1 month.
In a Bear market, 4% in 1 month is good. If my options go unexercised, I would see 11% in 2 months or 5.5%, just above this 4%. So it's pretty good for 2nd place.
Or I can keep the stock, take the 4% net on the call, and see what happens. I can always write another call.Scenario #3: ETFC <$3.35 Anything is possible, but the stock is clearly breaking down and re-visiting short term lows. After all, that is at least 11% below my purchase price and 25% below it's recent high. In any case, the $4 May call is probably super cheap: ~$.10. If i think the stock could crash further, I could sell the stock, I could close the call option and sell the stock, or I could close just the option and assume that this was a short term drop and that the stock will rise again. The key assumption here is that the stock isn't going down more than 15%~20% for any length of time. That is a VERY dangerous assumption and very risky. I am mitigating that risk (I hope) by carefully choosing a stock that seems to have bottomed. One last thing, I am deliberately writing short-term calls: 1 or 2 months at most. This gives me a good return while also retaining some flexibility. I actually hope for 1 of the following 2 scenarios: 1. ETFC >$4 in May. Lock in 18% in 7 weeks.
2. ETFC $3.35~$4. I would write another set of contracts, hopefully also for 11%.
My hope is that eventually the options are exercised and someone takes my stock. But not after I yield 11%+ a few times.
If I do this twice and drop my cost basis to ~$3 and then sell >$4, that's a nice 33% return.
posted by Andrew at
3:49 PM
5 Comments:
Out of the above scenarios I think the scenario 1 is most likely at least for the short term.
I think it’s bit risky to pick a volatile stock for writing covered calls... you have to quick on your foot (as folks will excerise the options before expiry and premium value keep changing) and be on the market always with your moves.
Market should pick up this week barring any unexpected bad news; Dow might gain 300 points by Thursday before Wal-Mart & Target report. I also expect India and Hong Kong markets to gain at least 10-15% in April before any sell off starts. Lot of foreign money has gone into these markets since last 2 weeks and also the domestic funds are waiting in the sidelines to get deployed. The rally in April may fade as we go into May and June.
Thanks Andrew for the education, it was helpful. I sincerely appreciate your time to explain all the scenarios and what happens.
Is there an e-mail or a contact page to get ahold of you?
2 weeks ago I compared this cycle with previous cycles and concluded that a run-up to 12,500 wsa likely before it crashed again. This time to 11,400.
Moreover, with tax season 2 weeks away, I think we'll see a net outflow of money.
Add in bad economic news and disappointing corporate earnings releases, and I don't think we'll be heading up.
I can be reached at azatlin@gmail.com
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