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
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
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
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