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- 27 March 2024
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Let's jump into another options strategy to accommodate stock portfolios. My previous post was a stock accumulation strategy (a cash-secured-put alternative), this time I wanted to cover a strategy that can enhance existing stock portfolio holdings.
Now I was contemplating writing about the well-known 'Covered Call' strategy, which is structured generally as an OTM call option that has equal share quantity to the number of shares you own. This is a great strategy to extract extra premium from your holdings, but the downside is giving up your right to the upside of your stock and risking having to sell your shares.
I'd assume most long-term stockholders are in a position of carefully selecting stocks you've spent hours researching and developed a child-like relationship with your bigger holdings and wanting to hold and continue to hold over a long period of time. Why would you risk the loss of your favourite stocks with a covered call? What if you get assigned to sell your stock? You take in cash and have to redeploy, you lose of good performing stock, but worse of all you have a capital gains tax event; I'd argue not a great outcome for you long term portfolio owners out there.
Yes, you can trade European Options, roll your calls up and out for a credit and maybe, eventually get back OTM to keep the initial premium you receive, months and months after you place the trade - but I think for the time that takes, plus the fees you pay it really makes you question the value. You get into a position of chasing your tail to avoid selling your shares.
Anyone who has traded covered calls has been in the position where you sell the call, then the call gets takeout within the first week, and you sit there regretting selling the call in the first place.
If you're actually happy to sell your stock, this isn't really a problem. You keep the credit for putting the trade on, the stock goes up in value for a share increase and you lock in profits.
So, what can we do to lose that risk? Easy, set you covered call as a Call Credit Spread. Which is simply selling a call option, then buying a call option further OTM for a lesser price as protection, for a net credit trade.
It turns the payoff diagram from this for a covered call:
to this for a credit spread alongside a stock position (1:1 ratio):
The desired outcome is the same - you hope the stock stays below the sold call leg, that option expires worthless, and you keep the premium received. I've just moved the risk area by adjusting the trade as you can see above. But now, if your underling stock catches a flyer, you're not losing and all that effort picking this undervalued stock in the first place hasn't gone to waste.
However, common Covered call concepts apply:
- best in a sideways trending market with moderate to high implied volatility
- you could argue if you have no intention of selling the underlying, this also works in a bear market.
- if the stock is on a run, leave it - why try to pick a top?
- higher IV = higher premium
Key facts to note:
- a sold call will provide more premium (income) than the call credit spread
- a sold call caps your upside on your stock position, where a call credit spread does not. You just take the maximum loss of the trade while the underlying stock can still move up.
- you can still be assigned on the sold call part of the trade - consider Euro Options or managing early >2 weeks until expiry to avoid this.
- having 2 legs now gives great flexibility to roll into new trades depending on how the stock moves, as @wayneL has mentioned previously.
- consider volatility skew as mentioned by @ducati916, as a call credit spread, ideally the sold leg has higher IV than the bought leg for more premium collection.
- be careful of 'pin risk', a chance that at expiry the sold leg can be ITM and the bought leg OTM - I'd say if your sold leg is close to the share price at expiry its worth closing / rolling into a new position.
- Cash settled options - such as the XJO make this strategy even better, because you don't have to worry about assignment and losing your stock. @Gunnerguy has a fantastic example of this in a previous post on this thread on beta weighting the portfolio extracts low risk premium from Index options rather than with each individual stock.
Hope this helps.
Cheers,
VB
Now I was contemplating writing about the well-known 'Covered Call' strategy, which is structured generally as an OTM call option that has equal share quantity to the number of shares you own. This is a great strategy to extract extra premium from your holdings, but the downside is giving up your right to the upside of your stock and risking having to sell your shares.
I'd assume most long-term stockholders are in a position of carefully selecting stocks you've spent hours researching and developed a child-like relationship with your bigger holdings and wanting to hold and continue to hold over a long period of time. Why would you risk the loss of your favourite stocks with a covered call? What if you get assigned to sell your stock? You take in cash and have to redeploy, you lose of good performing stock, but worse of all you have a capital gains tax event; I'd argue not a great outcome for you long term portfolio owners out there.
Yes, you can trade European Options, roll your calls up and out for a credit and maybe, eventually get back OTM to keep the initial premium you receive, months and months after you place the trade - but I think for the time that takes, plus the fees you pay it really makes you question the value. You get into a position of chasing your tail to avoid selling your shares.
Anyone who has traded covered calls has been in the position where you sell the call, then the call gets takeout within the first week, and you sit there regretting selling the call in the first place.
If you're actually happy to sell your stock, this isn't really a problem. You keep the credit for putting the trade on, the stock goes up in value for a share increase and you lock in profits.
So, what can we do to lose that risk? Easy, set you covered call as a Call Credit Spread. Which is simply selling a call option, then buying a call option further OTM for a lesser price as protection, for a net credit trade.
It turns the payoff diagram from this for a covered call:
to this for a credit spread alongside a stock position (1:1 ratio):
The desired outcome is the same - you hope the stock stays below the sold call leg, that option expires worthless, and you keep the premium received. I've just moved the risk area by adjusting the trade as you can see above. But now, if your underling stock catches a flyer, you're not losing and all that effort picking this undervalued stock in the first place hasn't gone to waste.
However, common Covered call concepts apply:
- best in a sideways trending market with moderate to high implied volatility
- you could argue if you have no intention of selling the underlying, this also works in a bear market.
- if the stock is on a run, leave it - why try to pick a top?
- higher IV = higher premium
Key facts to note:
- a sold call will provide more premium (income) than the call credit spread
- a sold call caps your upside on your stock position, where a call credit spread does not. You just take the maximum loss of the trade while the underlying stock can still move up.
- you can still be assigned on the sold call part of the trade - consider Euro Options or managing early >2 weeks until expiry to avoid this.
- having 2 legs now gives great flexibility to roll into new trades depending on how the stock moves, as @wayneL has mentioned previously.
- consider volatility skew as mentioned by @ducati916, as a call credit spread, ideally the sold leg has higher IV than the bought leg for more premium collection.
- be careful of 'pin risk', a chance that at expiry the sold leg can be ITM and the bought leg OTM - I'd say if your sold leg is close to the share price at expiry its worth closing / rolling into a new position.
- Cash settled options - such as the XJO make this strategy even better, because you don't have to worry about assignment and losing your stock. @Gunnerguy has a fantastic example of this in a previous post on this thread on beta weighting the portfolio extracts low risk premium from Index options rather than with each individual stock.
Hope this helps.
Cheers,
VB
. But 1 day to go … fingers crossed for you.
