Noob question about options?

Discussion in 'Options' started by larryg003, Jul 10, 2010.

  1. larryg003


    I've started learning a bit about options and I have a couple of questions on covered calls.
    If you buy a stock and write a call that is deep, deep, in the money, you will have downside protection of
    Stock Price - Option Price.

    However, your profit will be much smaller. I've done several examples of this and noticed several things, that need some clarifying: If the call is sold deep in the money (and the stock also bought) and it is exercised, your payoff is really the time premium, right (assuming no transaction costs)? So a covered call that is sold deep in the money and exercised really has a maximum profit of the time premium, right?

    Because time premium increases on calls as we approach the stock price from low to high and decreases as you go from high to low, you get a higher payoff by selling calls with strikes closer to the stock price. i.e. you get a higher profit by selling a call which is for a strike of 35 as opposed to a strike of 30, if the stock is trading at 40. This is assuming you are pursing a covered call strategy and you have also bought the stock at 40. This also assume that your call has been exercised and your transaction costs are zero.

    This is not the case if the call is sold out of the money (and the corresponding stock also bought).
    In this case, you still have downside protection of stock_price - call price, but in order to achieve maximum profit, your stock must increase in price (To reap the difference between strike and stock price), right?

    I was initially thinking of pursing a covered call strategy with an option that is deep in the money, but because time premium decreases as we get farther from the stock price, it seems that you will have very small reward/small risk and a large transaction costs that will ultimately make you lose money.
    Therefore it's not a viable strategy for small-time individual traders.

    One more quick thing, I've been reading McMillan's book and he says, "unless a fairly deep in-the-money write is considered, the return [using] on margin will always be higher than the return from cash." The reason this occurs is because the interest you pay large interest on margin and coupled with transaction costs, your costs will weigh you down and cause you to have a smaller return then using plain old cash, right?

  2. Premium


    Instead of buying the stock and selling DITM covered calls, you could just sell OTM puts, which is an equivalent position but superior in terms of margin, slippage, and transaction costs (assuming your account allows cash-secured puts).

    The above position is the safest covered call position (most conservative) because the breakeven point is far below the current stock price. But the potential reward is the least, which would be the premium from the put sale.

    Selling the ATM covered call would get the most time premium, which is good. It provides less protection than the previous position, but greater potential reward. Also, you must be satisfied with the result if the stock moves higher and the whole position gets called away.

    Selling OTM covered calls gives the most potential reward because it allows for stock appreciation as well as the time premium of the option. Because of this, I would actually consider this as two separate trades instead of a single covered call position.

    You get higher premiums for longer term options and for high volatility stocks. My only recommendation is that you do covered calls for investment purposes and for stocks that you really like. Don't do covered calls for speculative trading unless you're very disciplined with a system because covered calls have a bad risk/reward ratio.
  3. minus dividend, because exercise happens the day before ex-dividend. McMillan's books/writings are less than worthless in my opinion.
  4. drcha


    You are doing very well for a noob-- thinking about these things correctly.

    I must respectfully disagree with the previous post. Keep reading McMillan; you will continue learning how to think about options.
  6. Dividend is irrelevent since it's your own money being given to you in a taxable event. and Compared to your drivel, McMillan is Shakespeare
  7. piezoe


    I am not an options expert, but i might offer a couple helpful ideas. One is to remember that only extrinsic value decays, so when selling a call in the covered call strategy, you are selling extrinsic value, so you want the option to have maximum extrinsic value, and you want that extrinsic value to decay as rapidly as possible. By selling you become long theta, so you will benefit from the passage of time. Selling the front month, atm option maximizes the extrinsic relative to the intrinsic. You will be short gamma and long theta. The long theta is what you want, because you want as rapid as possible decay of the extrinsic value you sold. When there is very little extrinsic value left, you should not continue to hold the short option position, but instead cover it by buying it back, because at that point there is little to be gained, as the extrinsic is essentially gone, and you are still at risk.

    Do not sell a deep in the money call (too much intrinsic, not enough extrinsic) , and do not sell a call several months out, even though the premium is greater (theta decays too slowly). Always sell the front month call. You'll do much better selling the front month call 4 times as apposed to selling the call four months out 1 time.

    I my opinion, you should only sell calls against stock that is in an established up trend. A slow steady uptrend is best. Avoid stocks that rise rapidly and are very volatile, as they are likely to be even more volatile to the downside!. Know before you enter the position where you will get out if it turns against you. For example, I would watch the stock, and if it closes below its trendline, I'd get out and take my loss.

    Finally, unless you already own the stock and are planning to hang on to it because it is trending up, you should consider using simulated long stock instead. You sell a front month atm call and buy a fairly deep in the money back month call, a strike with say a delta around .85 to .90. The latter simulates long stock but does not tie up nearly so much cash as actual long stock would. This position is known as selling a diagonal, and its a very common strategy in rising markets. The position needs to be rolled when the extrinsic in the short call has pretty much decayed, and if the delta of the long call has gone up, as it will if the stock price rises a little, as you had hoped for, then sell out the forward long call and buy the call a strike higher at slightly lower delta at the same time you roll your short call. Selling diagonals are what many option traders do as opposed to actual covered call selling because it is a more efficient use of capital.

    Finally the advice someone gave you on selling a cash secured put as being a synthetic covered call is not bad in my opinion. Many are afraid of short puts, but would not think twice about selling a call against long stock, not realizing they are equivalent positions. The downside is the same as for a covered call: the stock drops and you don't stick with your exit plan. You end up owning the stock at a price above market. Remember puts can get very expensive fast if a stock begins to plunge. I only sell puts on stocks I like to acquire.

    I would urge you to study the Greeks first, and then begin trading options. Though most do it in the opposite order, they pay a price for that mistake.
  8. If you're doing speculative trading with calls + underlining position, you're better off selling a call spread. Limited risk, known max return.
  9. xyannix


    I wrote an article on about a covered call trade on VVUS.

    Even though the option that was sold is deep in the money. $6 Call sold on a $10 stock. The downside risk is still there is the stock falls below $5.

    If you do a vertical spread, then your max loss will be lower.

    The reason people do a covered call in this case is because they say, "I dont mind owning the stock at a cost of $5" that is very nice and all but if the stock drops to $3 will they still say that?

    You will see with options that there are 25 strategies that are all slight variations of the same thing and it is up to the trader to decide which combo he likes for that particular stock.
  10. I thought the title of this thread was appropriate for my post, even though its not really related to the OP's. I hope he doesn't mind :)

    My first question is 1) For most of you guys trade options regularly do use strategies that are mostly directional, or market neutral ? and 2) If you say market neutral, why?..if you're unsure of the direction, isnt it just best to stay out of the market at that point?

    Also I've been reading "Get Rich With Options second edition" by Lee Lowell. He's a big fan of DITM calls/puts and says why would you ever pay for stocks ever again if you can buy the options at 50% discount with 1.0 deltas? He makes it sound very attractive. Is it really all that and a bowl of cherries? If so I'm selling every stock I own right now! :p

    #10     Jul 13, 2010