Covered Calls

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Mar 2, 2006 9:35 am

I've been reading some of the posts on covered call trading but still in the dark on some of the mechanics.  If my client sells a covered call option can his stock really be called away or can he just settle up for the value of the call at expiration.  If the stock does get called away do I get paid for the transaction or is it part of the covered call transaction?

Mar 2, 2006 9:51 am

Go to CBOE website. Lots of info. All your questions can be answered there.

Mar 2, 2006 11:15 am

A problem you must deal with is that equity options are "American Style" which means the option owner may exercise them at any time.


Generally speaking most are not exercised early because there is no reason for the call owner to invest the additional thousands of dollars in the shares when they can wait to do it later.


However, there are two major reasons to exercise early.


1.  The stock is going to trade "ex dividend" tomorrow and the call owner has decided that they are going to add the thousands of additional dollars to become a shareholder.


Essentially their thought process is, "I'm going to pay the additional (ie) $50 per share sooner or later so is it better to pay the money now and get the dividend for wait and pay the same sum but not get the dividend?  Obviously buy it now and get the dividend.


What this means is if you have a customer who is selling covered calls you must pay close attention to the ex-dividend date.  On the day before you should check to see how the value of the call relates to the value of the stock.  How much is it "in the money?"


I'm about to wander off into a long discussion of time value versus intrinsic value coupled with opportunity value and a bunch of other stuff.  Let's just say that if you're short covered calls on a dividend paying stock you will quite likely end up losing the stock early because of the dividend.


2.  The other issue is this.  A certain percentage of calls are bought by professional traders who use them as part of a master strategy that is bearish.  Often they'll short the shares and buy calls to protect themselves.


If you wrote calls on a stock that was trading at (say) 45 when you wrote them, but the stock is now (say) 70 there is an excellent chance that you're going to wake up one day and be notified that call the call owner exercised their right to buy the stock at 45 and you're the one who is going to have to deliver the shares for $45 per share.


This won't be an issue if the stock has not gone up much or is a volaile issue like Google.  But it can be a problem.


Next.  Yes it is possible to buy back the options on the day before they expire. You can get enough to pay for them by selling another one with several months to go.  For example on March 17th I expect to have to buy back some calls. To get the money I will sell June calls with the same strike price. June contracts are always going to be worth more than March contracts because they last longer.  The problem is that the difference between the two premiums (and their bid and asked differentials) is only enough to pay the commissions.  But at least I buy more time to be right on the call.


Finally, if you are assigned early--meaning you must sell before you expected to have to sell--you can ask your broker dealer to consider your trade to be a "short against the box trade" meaning that borrowed shares are delivered to satisfy your sale and you still own your original shares.  The benefit to this is you do not realize the capital gain, which can be huge if the client is writing against low cost basis shares.


There is no reason why people who own shares should not at least consider the benefits of writing calls.  A well diversified portfolio can return upwards of 20% per year in flat or rising markets.  Not as good as it might be in a huge bull market, but you don't go broke generating those types of returns.


If you're willing to use margin the returns can be even better.


If you work for a wirehouse you should begin to pay attention to the firm's options marketing group.  They will provide you excellent ideas on story stocks that are easy to present.


Oh wait, I forgot it's all about Assets Under Management.  Never mind.

Mar 2, 2006 11:27 am

Big Easy,  thanks for the detailed info.  Anyone else know anything about the comp issue?  If the shares get called away do I get any $ for that, or is it considered part of the covered call transaction?

Mar 2, 2006 12:36 pm

You'll get paid, but focusing on whether you get paid or not is a sure way to end up in court.

Mar 2, 2006 12:40 pm

Adding that for a moment.


Those who engage in a covered call writing strategy generate significant commissions.


1.  A commission to buy the stock


2.  A commission to sell the call


Later there will be some combination of these


1.  A commission to sell the shares if they're called away


2.  A commission to buy back the options and another commission to sell another one


3.  A commission to reinvest the money received from the stock that was called away plus a second commission for the calls that will be sold against that new position.


It is not uncommon for an account that uses margin and gets called away a lot to end up paying commissions equal to about 20% of the assets in the account.  Plus generate a very attractive return.


Oh wait, I forgot.  It's all about assets under management and trails.  Transaction oriented brokers are a thing of the past.

Mar 2, 2006 12:52 pm

BEF...I haven't been paid when my client's shares were called...my firm simply delivered the shares out (they may have charged a reorg fee...don't remember, but if they did, I didn't see any of it)...you sure about that part?

Mar 2, 2006 6:37 pm

That's the joy of being an independent, you have no idea what is happening to  your accounts.


In the wake of your question I made a few phone calls--every one of the guys (well, and a broad too) I talked to said that at their firm the client pays a commission when they are assigned on a call option.


In other words, you get a commission when the client buys the stock, one when he sells the call, one when the stock gets called away, one when you reinvest the money in another stock and one when you write the call against the new position.


Ain't this country grand?

Mar 2, 2006 6:58 pm
Big Easy Flood:

That's the joy of being an independent, you have no idea what is happening to  your accounts.


Uh, yeah I do know what happens with my accounts...and I know they are not getting nailed for the fourth time when their stock is called away, so your assertion is far from universal.

Mar 2, 2006 7:29 pm

Fouth time?


One is when they buy the stock.  Two is when they write the call.


Three is when they're assigned an exercise notice.


If you're hitting them a fourth time you're being very unfair.

Mar 2, 2006 8:44 pm

Aren't you cute?!!  Your example indicated five commissions, although I realize that you were including two different stocks.  OK, I'm hitting them twice...you're hitting them three times...now who's being unfair?

Mar 2, 2006 8:49 pm

You can't stay in this business giving your services away for no charge.


If the client sells their shares they should pay a commission.


Why do you disagree?

Mar 2, 2006 9:37 pm

An exercise IS a sale. Ergo, commision charged. Simple deal....you explain all this going in to the position. If client doesn't like the charges, you don't put on the positions. What the H is so difficult about all this? 

Mar 2, 2006 9:52 pm
Indyone:

Aren't you cute?!!  Your example indicated five commissions, although I realize that you were including two different stocks.  OK, I'm hitting them twice...you're hitting them three times...now who's being unfair?



Actually if you're good you can get five commissions every six months.  Ten a year and you never lose control of the assets.


Isn't the role of a registered representative to turn client assets into commission as quickly as possible?

Mar 2, 2006 10:15 pm
Big Easy Flood:

Isn't the role of a registered representative to turn client assets into commission as quickly as possible?

My role is to put my client ahead of commissions...and I do that while making a very nice living.

Mar 2, 2006 10:18 pm
Revealer:

An exercise IS a sale. Ergo, commision charged. Simple deal....you explain all this going in to the position. If client doesn't like the charges, you don't put on the positions. What the H is so difficult about all this? 


It's not difficult.  It's just not the way everyone does business.  I know that my last B/D did not charge for delivering shares.