Option volume is starting to pick up the past couple of days so it appears that traders are starting to notice that market has experienced a nice run this summer. Since June 1st when the SPX closed on a low of 1278.04, Friday’s close of 1437.92 represents a gain of 12.5%! That’s really impressive especially with the doom and gloom being prognosticated across media outlets by the markets talking heads. One message that can’t be disputed is the fact that the Euro zone debt crisis isn’t over just because some Euro Central bankers say it is. The election in the US is still a wildcard and future implied volatility is still upwardly sloped. This indicates the options markets are predicting more movement than what we have been experiencing recently, the historical 30 day actual volatility of 10.33%.
On September 10th the selloff is just a small reminder that equity prices that exhibit positive momentum don’t go higher continuously. This reality should lead at least some to wonder if it is time to take some chips off the table, and how best to do so?
If you are of the mindset that now is the time to reduce and pull back, but you don’t want to just sell or close your long equity exposure there are four option strategies which could be considered depending on your outlook and risk tolerance:
I. Over write long stocks
II. Portfolio SPY puts and put spreads
III. Stock replacement strategies: Long Calls vs. Long Stock
IV. Convert to spreads – naked long calls and naked short puts
Today I am going to discuss Over Written calls or Covered Calls.
A Covered Call is one of the first option trades stock traders employ, with good reason. An overwritten short call (Covered Call) on a long stock position can be used to do all of the following, pick an exit point, generate income from a stock holding, or reduce the amount of the current long exposure to a naked long stock position. A full description of the covered call strategy is available on our webinar archive in the strategy section here (link to webinar archive).http://optionshouse.com/webinars/strategy-corner/neutral-options-strategies-covered-calls-and-short-puts/ When used in the context of pulling some chips off the table, I would first use the delta of the call to determine the percentage of long stock exposure you wish to reduce. Delta is the option “Greek” which measures the theoretical price move expected for a 1 point move higher in the underlying stock price. The range in deltas for calls is 0-1.00, but since options are contracts on 100 shares of stock most professional traders refer to call having 0-100 deltas. So for example in Apple (AAPL) stock if I were fortunate enough to be long 100 shares for this year’s run up I could look at a 25 Delta call to reduce 25% of my exposure to Apples price move. Remember I am selling the call so the short call is short 25 deltas. Combine this with long 100 shares of stock, and your resultant exposure is now 75 shares. If you want to take more “off the table”, increase the delta of the option you sell. The higher the delta the higher the premium you will receive, but the strike will be closer to the current stock price and the higher the chance that your stock may be called away from you at expiration.
I also need to determine which expiration month I want to overwrite my call. The longer the time to expiration the higher the premium you will receive. November options expiring in 66 days, would take us through the new iPhone release, another earnings date (10/23)as well as the US election. Also there is an expected dividend again falling around this date so be aware of that. The 25 delta option occurs in the 730 strike in November which sellers can receive a 13.50 premium. Notice only now I am looking at the premium I receive. My evaluation was based on the percent of 100 share exposure I wanted to reduce as well as the term I am willing to be short the call and have the obligation sell my shares at a predetermined price. Now looking at the premium I can determine if I am comfortable with the amount I receive today as an exit point in the stock and the amount of downside protection this premium provides. $13.50 is around 2% of the price of AAPL shares 668.00 at the time I write this. Selling this call option will offset a 2% decline in the share price of the stock between now and expiry, offsetting losses down to 654.50. Also you have to be comfortable with our exit point if the stock is called away. The 730 strike price plus the $13.50 premium equals 743.50. This is the price point you will be obligated to sell your long shares should the stock be higher than 730 at expiration. That level is roughly $75.50 higher than the current stock level or 11.3%.
Sounds good, but remember nothing comes free in options. The stock has gained 65% year to date and just yesterday the shares fell over 2% in a day! The point being this stock does move. Remember you cannot sell your stock without buying back the short call unless you have suitability for naked options and sufficient margin equity to cover the short call.
This is not a buy sell or hold recommendation, but simply an example of how you can look to overwriting a call option to take some chips off the table on specific appreciated stock positions. Later, I will discuss the portfolio put strategy to achieve the same.
Prices and examples taken from September 11, 2012.