# Selling call options with intent to get exercised



## stock_man (18 September 2006)

Hi all,

I have been following some very liquid options, and have made the following observations. Can someone please help me to clear this strategy up:

Purchase 1,000 BHP shares (closed today @ $25.22) = $25,220
Sell 1 $24.50 October call option (@ $1.5) = $1,500
Will most likely be exercised at $24.50 = $24,500

Outgoings = $25,220
Incomings = $26,000

Gross Profit = $780

Take out brokerage, and the profit is still around $500 depending on fees etc.

If for some freak chance you don't get exercised, the profit is $1,500 (less brokerage).

Am I missing something here?


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## Realist (18 September 2006)

What if BHP is $20 in October?


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## stock_man (18 September 2006)

Realist said:
			
		

> What if BHP is $20 in October?




Good thinking. However to counteract the possibility of the sp falling, you could take out a put option but it would be eating away at profits.

With a highly liquid option stock, would it not have a good chance of being exercised fairly quickly, thus negating the worry of the sp dropping too far?


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## Realist (18 September 2006)

stock_man said:
			
		

> Good thinking. However to counteract the possibility of the sp falling, you could take out a put option but it would be eating away at profits.
> 
> With a highly liquid option stock, would it not have a good chance of being exercised fairly quickly, thus negating the worry of the sp dropping too far?




If you do all that then after brokerage, and taxes and 1 months worth of inflation (bugger all I know). You'll end up with bugger all surely?  

Is it worth it?


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## stock_man (18 September 2006)

I know its not big time money, but would you honestly turn away $300/month?


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## Realist (18 September 2006)

stock_man said:
			
		

> I know its not big time money, but would you honestly turn away $300/month?




No, but you would get about half of that leaving your $30,000 in the bank.

You'd get more if you just bought WDC, WOW and RIO shares and held them a year I reckon.


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## GreatPig (18 September 2006)

stock_man said:
			
		

> With a highly liquid option stock, would it not have a good chance of being exercised fairly quickly, thus negating the worry of the sp dropping too far?



If the share price was dropping, why would they exercise the option? Surely they'd just sell it if they wanted to get rid of it.

In theory, I believe the only time early exercise of a call is potentially beneficial is just before a dividend.

GP


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## stock_man (19 September 2006)

GreatPig said:
			
		

> If the share price was dropping, why would they exercise the option? Surely they'd just sell it if they wanted to get rid of it.
> 
> In theory, I believe the only time early exercise of a call is potentially beneficial is just before a dividend.
> 
> GP



But what about if you sell a call option that is in the money? (3% by my example above)


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## professor_frink (19 September 2006)

you could just write a naked put.


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## stock_man (19 September 2006)

I was looking more towards a fairly low risk way of returning some consistent profit. Trying to balance out portfolio.


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## sails (19 September 2006)

stock_man said:
			
		

> But what about if you sell a call option that is in the money? (3% by my example above)



It is extremely rare to be assigned early except ex-div and the like as GP has already explained.  Just think about the other side of the trade - the person who is long your $24.50 call (very likely a market maker).  They are not going to exercise that call until there is absolutely no time value left and, even then will most likely wait until expiry even if it's deep in the money.  

If the market comes down below $24.50, then that option is made up of all extrinsic value (time value), so still no reason for the long holder to exercise -more likely they will sell the call to recover as much as they can if they want to exit their position.

PF is right in pointing out the alternative of writing a naked put.  The monetary risk of selling the Oct 24.50 put is on par with selling the 24.50 covered call.  It would also incur less fees especially if the market goes up and the put expires worthless.  If the market comes down, there is the same downside risk as the covered call.

Hope this helps!


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## Magdoran (20 September 2006)

stock_man said:
			
		

> Hi all,
> 
> I have been following some very liquid options, and have made the following observations. Can someone please help me to clear this strategy up:
> 
> ...



Hello stock_man,


Just a word of caution about using naked positions.  Please be aware of the unlimited risk characteristics of using a naked put (have a look at the chart below (I set the graph to move in line with the bar charts, and the different colours represent 1 standard deviation).



			
				professor_frink said:
			
		

> you could just write a naked put.



While not wanting to give specific advice, to illustrate how puts work generally, using a fall in BHP as an example to $19.37 would result at expiry in a loss around $5000 (please see attached chart).  This is the characteristic of selling a naked put, and significant collateral is involved.

May I suggest that you consider continuing to research options as you are doing for a fairly lengthy trial period before you actually embark on any real trades, perhaps by conducting paper trades, as there are complexities that are not always evident?

The covered call example you used is sometimes deployed by some investment houses, but they have a long term hold policy, and often factor corrections into their models.  Some do buy puts for protection, quite true.  But this is often portfolio management with a long term risk mitigation and additional revenue generation strategy.  This is worth considering, but ties up capital.  

An alternative approach to this kind of longer term investing is to use appropriate warrants with a bought put for protection and a sold call in a similar strategy, but again, you need to fully understand each instrument, and the entire strategy.  This is not really appropriate for newbies as there are risks involved that really need to be fully understood, unless you access expert advice or reach a level of competence where you are aware and comfortable with the risks involved, and develop suitable management strategies.

The real danger of your original scenario is that there is downside risk with any stock, and if you balance the real risk to reward, all you need is one bad move and this can potentially wipe out months of profits in a short period of time.


Hope this helps


Regards,



Magdoran


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## happytrader (20 September 2006)

Hi Stock_man

I like your covered call strategy. Those are also good figures for known risk and time in the market. I also take my hat off to you for your attitude of accepting both.

As for naked positions, it really is about intent and attitude too. Only you could answer the question 'If my put was exercised would I be happy to buy the underlying share at that price?' Its great if that was your intention anyway. 

Cheers
Happytrader


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