writing (i.e., selling) covered calls

what it means

Writing a call means entering an option contract in which you agree to sell shares in a stock to the counterparty at a specified price, if called upon do do so during a specific time period.  “Covered” means you own the stock in question. (See my post on calls and puts on stocks for more information.)

why do it?

You get a fee, called a premium, for doing so.

It’s possible that you feel the stock is at a short-term high point and likely to decline, but you’re a long-term holder and don’t want to sell.  By selling a call that you believe will expire unexercised, you collect a couple of percent of extra income.

It’s possible that you feel the stock is significantly overvalued and want to sell.  Selling a call that you feel is bound to be exercised nets you a somewhat higher price.

It’s also possible that your action isn’t an isolated decision–that you maintain an options overlay on top of your entire stock portfolio as a way of generating extra income.

two main presuppositions

In any event, the act of selling covered calls has two main convictions behind it.   Explicitly or implicitly, you believe:

–it’s better for you to forego possible capital appreciation in return for extra current income, and

–you’re able to make accurate judgments about whether stocks are cheap or expensive in absolute terms (that is, not just in relation to one another–see my post on relative and absolute performance).

why most professionals don’t do this

Professionals compete with one another on their relative performance, not their absolute returns.  So they’re not used to thinking or acting in absolute performance terms.

Absolute stock price judgments are harder to make than relative ones.

In many cases, the contract with customers won’t allow options purchases and sales.

To make a noticeable difference in overall performance, a professional portfolio manager would have to write calls on a large portion of his portfolio.  This is risky.  Early in my career I worked for a manager who had been one of the super-stars of the Seventies.  Beguiled by a then-prominent technical analyst, he became convinced that the big bull market that started in mid-1982 was a bear market rally.  So he sold calls on the majority of his portfolio.  The stock was all called away.  His performance was destroyed for a half-decade as a result, and he faded into oblivion.

why it may make sense for individuals

Although the strategy may result in lower total returns, individuals may well have a preference for income find that it fits their investment objectives.

In my experience, individuals don’t have fifty- or one hundred-stock actively managed portfolios.  They have far fewer positions.  So it’s at least possible that they get to know the short-term trading patterns of what they hold better than a professional who has much different objectives.  In other words, an individual may end up being good at this.

calls and puts on stocks: simple derivative instruments

In a recent post on the Macau gambling industry, I wrote that I had sold covered calls on WYNN, something I said I never would have done as a professional portfolio manager.

I want to explain what I’ve done, why, and why I’m willing to do it now when I wouldn’t do it then.

I’m going to do so in two posts.  Today I’m going to write about what (American) options are and the mechanics of buying and selling.  Tomorrow, I’ll write about why.

what they are: tons of terminology

As with most areas of finance, the basic ideas behind options are relatively simple.  Things get complicated, however, because there’s jargon to learn and because the markets can’t resist the urge to tweak the basics a bit to offer something slightly different.  As time progresses, the steady accumulation of simple tweaks creates the impression of incredible complexity, when it’s only simple ideas applied numerous times.

Here’s my attempt to untangle the options story:

general

Derivative instruments are securities whose value derives from that of some other, benchmark, security.

Stock options are a type of derivative contract.  Options give the holder the right–but not the obligation–to transact in a given stock during a specified time period.

Calls give the holder the right to buy the underlying stock from the person on the other side of the contract at the specified price.

Puts give the holder the right to sell the underlying stock to the person on the other side at the specified price.

American-style stock options are exercisable at any time during the life of the contract; European-style (I’ve never owned one) are exercisable only at expiration.

Most stock options in the US are exchange-traded; that is, they have uniform characteristics and are regulated/guaranteed by the Options Clearing Corporation, which matches buyers and sellers.  There are also over-the-counter options, which are private contracts between an investor and an investment banker, but this isn’t anything we need to worry about.

The OCC has established standard contracts for options.  Under normal circumstances, contracts:

–involve 100 shares of the underlying stock

–have an exercise or strike price that’s set at a standard amount and at a specified interval from other options on the same stock, usually $5, and

–expire at a standard time during the third week of the month.

buying and selling

Not everyone can buy and sell options.  You have to satisfy your broker, usually by filling out a standard form, that you understand the risks of options trading and have the means to settle any trades you may make.

four possibilities

There are four possible positions for an options trader to be in:

1.  long a call, meaning you own the right to buy a given stock at the specified price,

2.  short a call, meaning you have agreed to sell the stock in question at the specified price to a buyer in the #1 position, if he exercises his right.

3.  long a put, meaning you have the right to sell the given stock to the person on the other side of the contract at the specified price.

4.  short a put, meaning you have the obligation to buy the stock in question at the specified price, if the buyer in #3 exercises his right.

In cases 2 and 4, the trader has to  set aside collateral to show he can satisfy his obligation, if need be.  In the case of the seller of the call (#2), he may already own the stock in question.  If so, he is said to be selling a covered call, meaning he can satisfy his obligation by delivering the stock he owns to the buyer.  The stock is his collateral.

finding prices

If you get a price quote and chart for any stock on Google, Yahoo or on your broker’s website, there should be a link on the page that’s labelled “option chain.”  Clicking that will get you a list of all the available puts and calls on the stock, organized by expiration date and by strike price.

The list will show you the last trade, the bid-asked spread, today’s volume, and the “open interest,” meaning the total number of contracts outstanding for that strike price and expiration date.  The prices shown will be per share amounts, so you have to multiply that number by 100 to get the total dollar amount involved in buying or selling a single contract.

valuation

Professional options traders use highly complex mathematical models to price options.  The main components of valuation end up being the volatility of the stock in question and the time remaining until the expiration date.

In very simple terms, value can also be separated into two components:

— intrinsic value, meaning any portion of the option price accounted for by the price of the underlying stock.  Example:  if the option strike price is $25, the option is trading for $5 and the stock is trading at $28, the option would have $3 in intrinsic value.

time value, meaning anything other than intrinsic value.  In the case above, time value would be $2.

That’s (more than) enough for today.  Tomorrow’s post will be on using this information.