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Q: What is the risk in selling a covered call at a strike price considerably higher than the stock price at the time I wrote the call? If the option is exercised, I will profit from the call premium plus the difference between the stock purchase price and the strike price. It seems to me that the only risk is less profit if the call is exercised. What am I missing?
A: Whenever you write a covered call, you first have to decide that you would be happy to lose the stock at the net effective sale price (NESP= call strike price plus call premium). If NESP does not provide you with the profit you anticipated when you first acquired the stock, you probably should not write the call. Keep in mind that writing a deep out-of-the-money call (or, as you stated, "a�call at a strike price considerably higher than the stock price") may offer very little premium. You will want to ask yourself if the net premium, after the transaction costs, is enough to justify the transaction. There is a rule of thumb often employed by many covered call writers: the potential return, if the stock is called, should be about twice the risk-free (Treasury bill) rate. As an example, if a 60-day Treasury yields 5% per annum, a two-month covered call write should produce an annualized 10% return.
A corollary is that the return engendered by the covered write should at least equal the risk-rate if the stock remains static. Another guideline regarding premium is that the downside protection gained by call writing should at least equal 3% of the stock's current market price.
Q: I sold a naked call and then bought the same call. Is my naked call now covered?
A: Generally, if someone purchases the same call that was sold, it's likely that the two transactions would be matched as opening and closing transactions and the position would be eliminated. While not common, there may be some strategies where an investor wishes to remain long and short on the same contract. If this is the case, the naked margin requirement would be eliminated, but the position still bears the risk assignment on the short call option.
Q: Can I "roll over" options for an additional period of time?
A: The term "rolling" means that an existing option position is liquidated and a similar position is established to replace it. If the replacement position differs from the original position with respect to only the exercise price, the position is said to have been "rolled up" or "rolled down". If the only difference between the positions was the in the expiration month, you've "rolled out" the position. Suppose that six months ago, you wrote XYZ September 20 call, collecting 2 1/4 (less commission). If the XYZ has remained fairly stable, the call might now be offered at only 1/8. You could buy back the call for 1/8, netting 2 1/8 before commissions. And, if you still felt that XYZ's volatility and direction would not change appreciably, you could "roll out" and write the XYZ March 20 call and collect a 1 1/4 premium. So far, you've booked a cash inflow of 3 3/8 or $337.50 (less three commissions). However, if you're doing covered call writing (writing calls against stock actually owned) you'd only risk selling the stock at the strike price if the calls were exercised by the buyer. So, rolling covered call option positions forward could be a useful means to enhance the return on stock owned in an otherwise stagnant market. Alternatively, you could have rolled down and out your position. Selling the XYZ March 17-1/2 call instead could have garnered 85% more premium, 2 5/16, but left you exposed to sell stock at a lower price if assigned.
Q: I am working on a project involving American options. I would like to obtain information about a trading strategy that involves: buying an American put option and selling simultaneously the same American put option. Is this trading strategy feasible? Are the two trades offset, or does both a long and a short position appear in my account if I engage in the above trading strategy?
The motivation for buying and simultaneously selling the same American put option is that as a buyer I can use an optimal exercise policy for the American put option and then expect as a seller that someone has a sub-optimal exercise policy. I profit from this trading strategy if I am "lucky" to be chosen to buy the underlying asset when an agent who bought an American put option exercises the option sub-optimally.
A: First of all, if you simultaneously buy an option and sell the same option you will have a flat position with regard to that option. Of course, if you did the trades in different accounts or with different brokers the positions would not offset, but since you would be simultaneously long and short the same asset, from a strictly economic point of view you would still be flat. The simultaneous purchase and sale of identical securities on behalf of the same entity could be considered a manipulation of the market and in violation of various rules and regulations.
Secondly, you would have to enter into the trade. If you bought the ask and sold the bid, you would already be behind by the bid/ask spread. Putting out a bid between the existing bid/ask and then trying to hit your own bid with a sell order, assuming that there is no change of beneficial ownership, is definitely a violation of the rules.
Lastly, exercising your long put when it is optimal means entering into a short sale and earning interest. This means that your risk/reward profile would have changed radically, and if the stock should suddenly rally that position could suffer significant losses. And of course the whole profitability of the strategy involves earning interest on the proceeds of the short sale � how much of the interest earned does your broker rebate to you?
Q: Can I perform a spread by purchasing an at the money LEAPS call , and selling a front month out of the money call?
A: Yes, the strategy you described is also known as a "diagonal call spread." When considering implementing this strategy, you should be aware of the risks associated with the strategy, along with the (potential) rewards. In the worst case scenario, should you be assigned on the front month call and then exercise your LEAPS to cover the assignment, your loss would be the net debit paid to establish the position less the difference between the strike prices of the two options.
It�s more difficult to establish a maximum gain for this strategy, which in many ways resembles the Covered Call. The best case scenario is for the stock to go sideways or gradually rise over the life of the LEAPS call, thus allowing you to roll out your front-month option every month at a credit.
Q: I understand that there are discrepancies in options pricing between puts and calls and among the different expirations. Sometimes front months trade at much higher volatility levels and at other times the higher volatility is in the back months. But it is not clear to me how to benefit or to take advantage of this situation. For how long do these discrepancies exist, and where can I learn more about them?
A: It would be more appropriate to say that there are different levels of volatility and costs of carry for puts and calls and for different strikes and expirations. But this complexity is not artificial, it reflects actual differences in the factors that influence an options' price. For example, most options pricing modes are based on the Normal Distribution Function -- but stocks tend to deviate slightly from the Normal model, and traders compensate by tweaking the volatilities (skew) that they input into their model. In the case of puts and calls, the cost of carry tends to push calls to a premium and puts to a discount -- but the early-exercise feature prevents puts from falling below their intrinsic value, which distorts the put-call parity that would exist for European-style options.
Traders can and do take positions that benefit from changes in cost of carry, volatility skew, etc. But it's very difficult to calibrate such positions, and it generally requires making quite a few trades. So these types of strategies are usually only suitable for full-time investors who have very low marginal trading costs (although they often have high fixed costs, such as exchange memberships).
Q: What is the difference between a Call and a Put - and why does my broker tell me that I can't sell a Put when I'm long the stock?
A: An equity option is a contract. The call contract conveys to its holder the right, but not the obligation, to buy shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). The put contract conveys to its holder the right, but not the obligation, to sell shares of the underlying security at the strike price on or before a given date (expiration day). After this given expiration date, the option contract ceases to exist. If assigned, the seller of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price.
In the case of a covered call, the investor sells a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If an investor is assigned an exercise notice on the written contract he/she sells an equivalent number of shares at the call's strike price.
As for why your broker might have concerns about selling a put option while long the underlying stock, if the investor is assigned an exercise notice on the written contract he/she buys an equivalent number of shares at the put's strike price, effectively getting "longer" the underlying stock.
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