Motley Fool Options on Covered CallsHow they work by Jim Mueller, CFA

How to use them Advisor

Quick Review● Call is a contract between two parties

● Buyer (“long”) has right to buy shares at strike price○ Up until expiration○ Pays $$ (“premium”) to seller for that right

● Seller (“short”) must sell at strike if buyer says so○ Must do so until call expires or is closed○ Keeps premium regardless

Quick Review● Call is out of the money (OTM) if share $$ < strike $$● Call is in the money (ITM) if share $$ > strike $$

● Call will expire worthless if OTM at expiration

● Call will be exercised or must be closed if ITM at expiration

The Covered Call Position● 100 shares (long, “buy to open”)● 1 call contract (short, “sell to open”)● Call expires about 3 months out● Strike is usually 1 to 3 levels above share price (OTM)

● Net debit to establish○ Cost of shares minus premium received from call

Why Use It?● Most often, to generate income

○ Selling time value (TV), which decays to $0○ Hope to do this many times○ Eventually end up selling shares

● Sometimes to sell stock at a slightly higher price○ And get paid a bit extra on the way out

Setting It Up● Shares = $50

● Sell a $55 call expiring in 3 months○ Note, we sell an OTM call where premium is all TV.

● Get paid $2 to sell call

● Net debit of $50 - $2 = $48 (net cost to establish)○ Usually done in a single order (“buy/write”)

● If sell at $55, make $7 off $50 investment

Share $$ G/L Shares G/L Call G/L Total

$ 40.00 ($ 10.00) $ 2.00 ($ 8.00)

$ 42.50 ($ 7.50) $ 2.00 ($ 5.50)

$ 45.00 ($ 5.00) $ 2.00 ($ 3.00)

$ 47.50 ($ 2.50) $ 2.00 ($ 0.50)

$ 50.00 $ 0.00 $ 2.00 $ 2.00

$ 52.50 $ 2.50 $ 2.00 $ 4.50

$ 55.00 $ 5.00 $ 2.00 $ 7.00

$ 57.50 $ 7.50 ($ 0.50) $ 7.00

$ 60.00 $ 10.00 ($ 3.00) $ 7.00

$ 62.50 $ 12.50 ($ 5.50) $ 7.00

$ 65.00 $ 15.00 ($ 8.00) $ 7.00

$ 67.50 $ 17.50 ($ 10.50) $ 7.00

$ 70.00 $ 20.00 ($ 13.00) $ 7.00

Buy shares at $50.00

Sell $55 call for $2.00

What is Gain / Loss atvarious share prices atexpiration? OTM

ITM

G/L Shares

($ 10.00)

($ 7.50)

($ 5.00)

($ 2.50)

$ 0.00

$ 2.50

$ 5.00

$ 7.50

$ 10.00

$ 12.50

$ 15.00

$ 17.50

$ 20.00

G/L Call

$ 2.00

$ 2.00

$ 2.00

$ 2.00

$ 2.00

$ 2.00

$ 2.00

($ 0.50)

($ 3.00)

($ 5.50)

($ 8.00)

($ 10.50)

($ 13.00)

ITMOTM

You’re short the position.Therefore, value to you is negative.

G/L Total

($ 8.00)

($ 5.50)

($ 3.00)

($ 0.50)

$ 2.00

$ 4.50

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

G/L Total

($ 8.00)

($ 5.50)

($ 3.00)

($ 0.50)

$ 2.00

$ 4.50

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

$ 7.00

Breakeven at $48.00

Max gain of $7.00

Setting It Up: Guidelines● Yield: Aiming for minimum of 1% of TV / month vs.

share price○ $2 / $50 = 4% over 3 months (1.33% / month)

● Which strike?○ Depends on what’s available○ $1, $2.50, or $5 strike price increments are common○ Trade off between yield and potential selling price

■ Higher premium today means lower potential selling price○ Strikes closer to share price pay more, but have higher

chance of ending ITM

$55 strike$2 TV$5 gain on sale35% chance ITM at expiry

$52.50 strike$2.80 TV$2.50 gain on sale44% chance ITM at expiry

$57.50 strike$1.40 TV$7 gain on sale27% chance ITM at expiry

Setting It Up: Guidelines● Which expiration?

○ Depends on what’s available○ Want TV to decay reasonably quickly, yet pay well enough○ 3 months out is usual sweet spot○ If paying well (i.e., >2% TV / month), can do 1 or 2 months○ At most, 4 months

12-month call

6-month call

3-month call

How Does the Middle Play Out?● Boringly – we wait for expiration to come along

● If share price < strike price, no worries● If share price > strike price, usually no worries

○ Yes, you could be assigned early and must sell the shares. Rarely happens.

○ Remaining TV dictates what happens

TV RulesSame call, now 1 month out

Shares are $59, so ITM by $4

Worried about early assignment

$1.02 in TV remaining

Note, this means premium = $5.02

The call owner will not exercise early

If they do, send them a thank you card because you just made $100

TV Rules● You sell your shares for $55● You buy more shares at $59● You sell the same exact call for $5.02● Pocket $1.02

● $55 + ($59) + $5.02 = $1.02

● You’re back in the original position, $102 richer

TV Rules● Worried about early assignment? Calculate TV

● I don’t worry until TV is about $0.20 or less● Usually only happens in last few days before

expiration

TV Rules● One exception for early assignment risk: Dividends

● IF company pays a dividend,● AND covered call is ITM,● AND remaining TV < upcoming dividend,● THEN at risk of early assignment (dividend

poaching)

TV Rules● Same call

○ 1 month out○ $60 share price○ TV = $0.80○ Dividend = $0.60

● NOT at risk of dividend poaching

TV Rules● Same call

○ 1 month out○ $65 share price○ TV = $0.20○ Dividend = $0.60

● AT RISK of dividend poaching○ Call owner gives up $0.20 TV, but gains $0.60 dividend

How Does the End Play Out?● Two possibilities: OTM or ITM

● OTM: Share price < Strike price○ Let the call expire worthless○ Have earned the entire premium○ Premium rec’d is a short-term capital gain

How Does the End Play Out?● ITM: Share price > Strike price● Either:

○ Let the call be exercised■ Do nothing, happens automatically■ Will sell the shares at the strike price■ Premium rec’d added to selling price for tax purposes■ Short- or long-term depends on holding period of shares

○ Close the call (“buy to close”) prior to expiration■ Will pay IV + a tiny bit of TV to get this done■ Gain / loss taxed as short-term capital gain / loss

How Does the End Play Out?● Or: Keep strategy going:

○ Close (“buy to close”) the current, expiring call

○ Write/sell (“sell to open”) a new call

■ Higher strike price

■ Further out in time

○ Called rolling.

Rolling (credit)● Suppose shares at $57

○ Close $55 call for $2.05

○ Sell $60 call expiring 3 months later for $3

○ Net credit of ($2.05) + $3 = $0.95

● You brought in $0.95 more and increased potential selling price by $5 ($60 strike vs. $55 strike)

Rolling (debit)● Suppose shares at $60

○ Close $55 call for $5.05

○ Sell $62.50 call expiring 3 months later for $3.75

○ Net debit of ($5.05) + $3.75 = ($1.30)

● You paid $1.30 in order to increase potential selling price by $7.50 ($62.50 strike vs. $55 strike)

Rolling (debit)● You paid $1.30 in order to increase potential selling

price by $7.50

○ Worth it?

○ $7.50 gain / $1.30 cost – 1 = 477% potential gain on incremental investment.

○ Yes!

Rolling (debit)● Guideline:

○ For debit rolls (where it costs money), you want potential gain vs. cost of at least 50% per 3-month extension

○ Practically, don’t pay more than $3.33 per $5 increase in strike per 3-month extension. ($5 / $3.33 – 1 = 50%)

○ If cannot achieve this, time to let the shares go

Rolling● Allows you to continue the strategy● Brings in more cash along the way● Hopefully increases strike price● Eventually no good choices

○ So, let shares be called away

Rolling● Don’t worry if call is closed at a loss

○ The overall strategy’s gains more than make up for it○ Concentrate on the strategy gains, not leg gains

○ $55 call paid $2 to open, cost $5.05 to close, loss of $3.05○ Received $3.75 to open new $62.50 call○ Shares can now be sold for $7.50 higher than before○ More than makes up for $3.05 loss on that leg

○ Crazy Legs

Max gain of $7.00

Rule No. 1

Rule No. 1● If You Don’t Want To Sell The Shares, Don’t Sell

The Call!○ That maximum gain cannot be overcome○ Shares gain $1, short call loses $1○ Shares at $150 at expiration? You’re selling at $55.

■ Gain of $100 on shares, loss of $93 on the call = $7 gain○ Want capital gains? Stay away from covered calls or have

a separate long position.○ You can close the call to uncap the shares, but...

At share price of $70decide to close thecall to get more upside.

Cost is IV ($15) + TV.

Lose all gain between$55 and $70.

You still owe taxon that $15 risein share pricebetween $55 and$70.

Conclusion● Covered call is an income-generating strategy● Selling TV and letting it decay● Limited (and capped) upside● Near expiration, can let shares be called away or do

another round● Rolling up and out increases total strategy return

NEVER, EVER FORGET RULE NO. 1