Covered call question

Discussion in 'Options' started by serg007, Apr 19, 2005.

  1. serg007


    Hi everybody !
    I am new to this ET area, so please forgive me if this question was already discussed earlier.
    I am considering selling May call option on my current long DIA position, but I am doubtful about the mechanics of this trade.
    For example, the cost of DIA long is 101,50 and I can sell May call with 103 strike at $1.
    If on expiration DIA will trade below 103, no questions, I just pocket the $1 premium.
    But what happens if DIA goes above 103 before expiration and then falls ? Will the option be exercised ? (I've heard the options traded on US exchanges are usually American style).
    If it will, how it will be reflected on the account- will I have 2 different positions in DIA (long 101,50 ans short 103) or I will be squared ? :confused:

    I will really appreciate any reply :)
  2. Ninja


  3. MTE


    I suggest you get yourself educated before trading options, but to answer your question:

    You're correct, if DIA expires below 103 then you pocket the $1 premium. Options don't get exercised the instant they go ITM, so if the DIA goes above 103 it doesn't automatically mean that you'll be assigned. Generally spreaking, as long as an option has more than $0.25 time value the risk of early assignment is low, once the time value goes below $0.25 you may be assigned early, and yes, DIA options are American-style.

    In any case, if you're assigned (be at expiry or early) your calls are covered, which means that your stock position will be used to deliver on those calls. In other words, you'd be effectively selling your long stock position at the strike.

    By the way, no matter what happens, you still keep that $1 premium.
  4. serg007


    Thanks a lot, Ninja for the links and MTE for the detailed answer :)
  5. You should always ask yourself why you want to sell the covered call. I think if you read up on covered calls and understand the strategy better, you will get a better idea of what the mechanics are which strikes to choose, as well as what are good situations to do so.

    Now the heart of your question appears to be early assignment. the chances of being assigned early on a short option are pretty small if there is time to expiration and time value premium on the option. Now if the short call is OTM, the odds are small to none that you would be assigned early.

    If the short call is ITM and there is still a time value premium, the odds are also pretty low that you will be assigned early. When that time value premium erodes, the chances of being assigned early increases drastically.

    However, if you are assigned early your still will be called away for the maximum profit on your covered call position so it should not worry you.

    But as was pointed out, take the time to research and read the ins and outs of the strategy. Research before reward.

    Coach Phil
  6. serg007


    Thanks for input, Coach Phil :)

    Here is my reasoning. I have some long position in Dow from about 10150 but I don't believe it will rise sharply. Rather I wait for the small rally towards 10350-10400 and then resumption of downtrend. I am considering selling my long there, so why not to enhance return by pocketing some premium ?
  7. Selling the calls will reduce your basis slightly in your stock position and thus reduce your risk and provide a partial hedge. Of course this hedge is limited to the premium collected so just be careful if we start experiencing those 100 point down days again.

    If you selling covered calls and expecting a rally then you stand a chance of getting called out of your stock so you might not have to worry about making the decision to sell, it will be made for you- but at a profit! So in an upward trending market, covered calls take the guesswork out of your exit, as long as they are ITM by expiration.

    Like I said, covered calls make stock ownership less risky but you still have significant risk beyond the premium collected. So if the market starts going down hard (say below previous support at 10,000), get ready to pull the trigger to limit a big loss.

    Good luck!

    Coach Phil

  8. serg007


    Sure, stops shouldn't be forgotten :D
    Thanks again and good luck !

  9. If you don't think a position is going higher - why continue to hold it & have downside exposure -- The risk/reward of this strategy baffles me. Limited upside - unlimited downside minus $1.
  10. He did think it was going higher in the short-term as his post said. Whether he is right is another thing but his question was based on expecting a short-rally and wanting to add covered calls to enhance the returns and close out the position.


    #10     Apr 28, 2005