Covered call writing (selling stock options against your portfolio holdings) is a time tested and conservative method to enhance portfolio yield and reduce the risk of owning the underlying stocks.

A consistently implemented covered call program also reduces portfolio volatility, so that quarter-to-quarter returns will be closer to the longer term average return than without covered option writing.

It’s a Hedging Strategy:

The method is a form of hedging with a long stock position and a short option.

There are basically two types of covered call hedges: one using out-of-the-money (OTM) calls, and the other using in-the-money (ITM) calls. There are also at-the-money (ATM) calls, but they are less likely to be used.

ITM calls have an exercise (strike) price when written that is below the market price of the underlying security — they have some “intrinsic value” as well as some intangible value.  OTM calls have a strike price when written that is above the market price of the underlying security — they have no intrinsic value and only intangible value.

Use of Each Type:

A defensive hedge would use ITM calls — the deeper in-the-money, the more defensive the call.  That’s because ITM calls recover a portion of the market value of the underlying stock, as well as generate some extra cash.  We think a better approach, if you wish to be defensive, is to sell part of the stock position, and then use OTM options with the remaining shares.

An more aggressive hedge would use OTM calls.

The closer the OTM strike price is to the market price of the underlying security, the higher the option price (premium) and the larger the cash credit to the writer.  However, the closer the strike price is to the market price of the underlying stock, the more likely it is to be exercised; and the less gain will be realized by the writer on the underlying stock.

The farther the OTM strike price is from the market price of the stock, the lower the premium income to the writer, but the less likely the option is to be exercised; and the greater the realized gain would be if the option is exercised.

Do Covered Calls Limit Profits?

Not really.  Covered calls limit the profit potential on the specific shares that were optioned, but they do not prevent the writer from purchasing replacement shares immediately after the event of an option exercise.

There would be a taxable event for the writer when the option is exercised, but these days most people have ample realized or unrealized capital losses that minimize the concern about realizing a gain.

Who Can Manage the Process?

You can.  It is commonly practiced and anybody can do it.  The method is rather simple and can be managed by individual investors without the necessity of professional advice.  There is no mystery to it, just the need for careful consideration when putting on the hedge.

The challenge for a person new to covered call writing is the choice of option contract month and what strike price to use.  Let’s look at those two issues focusing on OTM options only.

CONTRACT MONTH SELECTION

Generally, you may be best served with contract 1 to 3 months out.

The time value of option premium decays exponentially, which means the rate of decay accelerates each day as the contract approaches expiration. The shorter the term of the option, the faster the time value wastes away.

Since your goal as an option writer is for the option to expire worthless in the hands of its buyer, the faster time value decay of shorter-term options improves the odds in favor of you, the writer.

Shorter periods of time provide less opportunity for your underlying stock to appreciate past the strike price.

Note that there is no economic incentive for the option holder to exercise until the market price of your underlying stock exceeds the sum of the strike price and the premium the option holder originally paid for the contract.

STRIKE PRICE SELECTION

The strike price choice is a minimization/maximization question.  You want a price far enough away from the market price of the underlying stock to minimize the chance of triggering an exercise (so you can keep the option premium money and continuously write new options as old ones expire).  At the same time, you want a price close enough the current stock price to maximize the premium that the buyer will pay for the option.

There are two key ways to make that choice — one using recent peaks and long-term resistance levels for the stock price; and the other using volatility to gauge how far the stock may appreciate over the life of the option.

Let’s explore these two methods using the gold ETF (GLD) as the example, assuming the writer chooses the May option contract (expires May 16), to go out two contract months past the nearly expired March contract.

Recent Peaks and Long-Term Resistance Levels:

Looking back as far as the option looks forward, there may be stock price peaks that could serve as both retest levels as well as resistance levels.

The May contract expires in 69 days.

You can see from the first image below that GLD had a recent high around $99 eleven days ago, well within the the last 69 days.  While GLD pulled back significantly, it is in an uptrend and may well test $99 again.  That would suggest a strike price above $99 to stay out of the range that might be traversed again soon to test that recent peak.

click images to enlarge

Recent High
(daily chart)

Longer-Term Resistance:

Significant resistance levels may be tested in an uptrend.  Positioning the strike price above important long-term resistance may reduce the probability of exercise.

The next chart shows a major resistance level from a year ago at just over $100.  That would suggest an appropriate strike price above that price.

Long-Term Resistance
(weekly chart)

Volatility-Based Probable Price Range:

The more volatile a stock, the greater the likely price range of the stock.

There are software programs, such as MetaStock which we used for the next chart, that will project a price forward probabilistically based on the historic volatility of the stock.

In this case, we projected the probable price range from March 6 through May 16 (the expiration date) based on 60 days of past volatility.  The three conical projections (A), (B), and (C) in blue, red and green are projected to 90%, 80% and 70% confidence levels respectively.

What that means is that 10% of likely prices will be outside of the conical projection for 90% confidence; 20% outside for the 80% projection; and 30% outside for the 70% projection.

In fact, the “outside” prices will lie both above and below the conical projections, but for conservatism sake, let’s assume they will all lie above the cones.

With that crude assumption, we would say that there is no more than a 10% chance that the GLD price would be above $106 by May 16.  Similarly, no more than a 20% chance of being above $103 by May 16; and no more than a 30% chance of being above $102 by May 16.

If the writer were to prefer to have a 90% chance of being able to keep the option premium money due to option contract expiration, the $106 strike price would fetch $2.35 per GLD share (2.5% of the stock price in 69 days).

That is attractive enough in terms of the general rule of thumb requiring at least 1% per month in yield from an expired written option.

Note that if the option were exercised, there would be no economic incentive for that to happen below $108.35 (the sum of the strike price and the option premium).  That would be a 17.4% gain over 69 or fewer days, and the writer could still replace the gold holdings and stay exposed to that particular asset even if the option were exercised.

Volatility-Based Probable Price Range

As it happens in this case, the recent peaks and long-term resistance are below the price probability projections.  We would rely on the projections in this instance.

Special Note: We are not suggesting that volatility and probability are magical crystal balls that foretell the certain future.  They do, however, roughly estimate the odds of an event happening or not happening.  That’s what we need selecting calls to write to attempt to put the odds strongly in favor of the call writer and only weakly in favor of the call buyer.

Conclusion:

Putting together recent peaks, long-term resistance and price projections based on volatility may be a fairly sound way to choose “safe” levels for strike prices.

Using 1-3 month contract expiration dates, puts time more on your side than that of the option buyer.

Making extra income from covered call writing on your portfolio holdings reduces the risk of stock ownership, lowers the volatility of your portfolio, and could possibly increase your total return.

Richard Shaw
QVM Group LLC

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