Managing a Portfolio of Covered Calls
by Ben Branch
In the June 2014 AAII Journal, I explored the pros and cons of writing covered calls on stocks that paid attractive dividends (“Assembling a Covered Call Portfolio on Dividend-Paying Stocks”).
Now let’s consider how to manage such a portfolio over time.
The Four Basic Outcomes
Once a portfolio of covered option positions on dividend-paying stocks is assembled, the investor needs to stay alert in order to take advantage of attractive situations as they arise and protect the portfolio from adverse situations that may come up.
Assuming the option remains in place as expiration approaches, four basic outcomes are possible. Table 1 summarizes the four possible outcomes and the actions that can be taken in each case. Below, each scenario is discussed in more depth.
The Stock’s Price Is Somewhat Below the Strike Price
First, the stock price could be close to but somewhat below the call’s strike price at option expiration. The call will, therefore, expire unexercised. This result should still produce a reasonably attractive return. At expiration, the investor may well want to write another covered call in expectation of a similar result. But before doing so, the stock should be reevaluated in order to make sure that it has remained attractive for covered writing. Is the dividend yield still generous? That is, does the yield continue to be attractive relative to average dividend yields and government bond rates and does it continue to look sustainable? Ideally, the stock should continue to have some growth potential. If so, and if other situations are not still more attractive, the investor should write new covered calls.
Once the stock position has weathered the first year, the potential of early exercise is less problematic. Moreover, the transaction cost of purchasing the stock has already been incurred. Accordingly, writing shorter-term calls becomes a bit more attractive. Such option writing has its own potential advantages. Short-term options tend to have a higher price relative to their length than do longer-term options. In addition, if the underlying stock price rises quickly, the option writer may be able to capture some of the price appreciation quickly and either write a new option or exit the position. Finally, the covered option writer may find his or her portfolio easier to manage if the expirations are spread out. So, the investor may want to consider writing new options with, say, three, six or nine months to run. The strike can either be the same as that of the original option or a bit higher if the stock price has increased.
The Stock’s Price Is a Bit Above the Strike Price
Second, the stock price may have risen a bit above the call’s strike price. Thus the investor has already earned the maximum return. If nothing is done to prevent it, the option will be exercised. The investor will be paid the call’s striking price, lose the stock and owe taxes on the gain (at the long-term rate if the position has been held for at least 12 months). The call writer should be pleased with the result. In many circumstances, that is not the best outcome. In particular, the stock may continue to be an attractive candidate for covered writing. If so, the investor may want to prevent the call from being exercised. This will put off any tax liability on the price appreciation as well as keep the stock available for covered writing. The process is straightforward. The investor simply purchases another option with the same strike and expiration as the one that was written. The two positions (short and long) offset each other. This short covering should be done on or slightly before the call’s last trading day. Usually the option will, at that time, trade for about its intrinsic value (the difference between the stock’s price and the call’s striking price). So if the stock is selling for $30 and the option has a strike of $25, the option will have an intrinsic value of $5 and should, near expiration, sell for not much more than $5.
Covering a short option position is a taxable event and any gains or losses are always short-term, as the sale occurs before the offsetting purchase. If the purchase is for a higher price than the proceeds from the initial option sale, the transaction gives rise to a short-term loss. If the call was bought back for less than the initial sale proceeds, a short-term gain is realized. In either case, the paper gain on the underlying stock does not give rise to any tax consequences as long as the stock itself is not sold. And then, assuming a year has passed, any gain realized thereafter will be long-term and thus taxed at an appreciably lower rate than short-term gains.
Once the call that was written earlier has been extinguished by an offsetting purchase, the investor is free to write a new covered call. Since the stock is now trading at a higher level, the new call can be written at a higher strike, above the current stock price. In this way the investor captures that part of the price appreciation reflecting the difference between the purchase price of the stock and the strike price of the first call that was written. And with the second covered call writing, the investor seeks a second bite of price appreciation in the form of the difference between the now-current stock price and the strike price on the call. This process will rarely capture the full price appreciation of a stock whose price is steadily rising. But it will capture some of the premium along with the dividends and the premium income on the calls that were written. As already discussed, the new option may appropriately be written for a period of less than a year.
The Stock’s Price Rises Substantially
Third, the underlying stock could rise substantially while the covered position is in place. This is the one time when the writer may well wish he or she had simply held the stock without writing a call against it. One could, for example, buy a stock at $30 and write a call with a strike of $32 on it, only to see the stock rise to $50. The investor has earned a reasonably attractive return (12% to 15%) on the position, including the proceeds from the option sale, dividend payments and the $2 of price appreciation. That level of return, however, pales in comparison to a $20 gain on a $30 stock (a gain of 67%). One who undertakes a program of covered call writing needs to understand and try to manage this kind of risk. Stocks that the investor believes have substantial short-term upside potential may be attractive investment candidates, but they are not ideal candidates for covered writing. The kinds of stocks suggested herein for covered writing, stocks that pay generous sustainable dividends, are generally from relatively mature companies that are less likely to experience very large price changes (either up or down). But they can on occasion be volatile (if, for example, they are subject to a takeover offer). Thus it is not always possible to avoid writing options on stocks that subsequently rise well above the call’s striking price. One who writes many covered calls will sooner or later experience the “pleasure” of seeing one of his or her stocks rise dramatically, knowing that most of that gain belongs to those who bought the calls. So what should an investor do when this happens?
|There are four basic outcomes an investor who writes covered calls could face as the option contracts approach their expiration. This table provides a brief overview of the available choices for action.|
|Stock price is close to, but below, thecall’s strike price near expiration||• Revaluate stock to ensure it is still attractive for covered call writing|
|• Consider writing another call, perhaps shorter in term|
|• If a few hundred shares are owned, consider writing contracts with varying expiration dates|
|Stock price is above the call’sstrike price near expiration||• Allow the option to be exercised|
|• Buy another option with the same strike and expiration to offset the written call contract|
|• If an offsetting call is purchased, evaluate the stock and consider writing a new covered call|
|Stock price rises substantially abovestrike price prior to expiration||• Allow the option to be exercised|
|• Buy another option with the same strike and expiration to offset the written call contract|
|• If an offsetting call is purchased, evaluate the stock and consider writing a new covered call|
|Stock price falls far below the call’sstrike price near expiration||• Let call expire unexercised|
|• Revaluate stock to determine if it is still an attractive investment|
|• Write a new covered call contract|
|• Sell the stock and write a put option at stock’s original purchase price|
Once again, the first step is to reexamine the stock as a candidate for covered option writing. Unless the dividend has been increased in line with the stock price rise, the stock’s yield will have declined. Moreover, the recent rise in the stock’s price may have left less room for a further rise, particularly if the stock’s price-earnings ratio is now appreciably higher. So, in many cases, the stock may be less attractive for writing further options. In that case, the investor may simply allow the call to be exercised. But if the investor does wish to retain the position and write another call on it, then the existing call needs to be extinguished with an offsetting purchase. While this process will involve paying substantially more for the repurchase than was received in the original option writing, the loss from the two trades (original call writing and then the offsetting purchase) will be short-term. And that loss will be offset by the increased price in the underlying stock, a gain on paper that will not become taxable until the stock is sold.
Note that harvesting short-term losses can be quite useful. An investor who maintains a covered option portfolio is likely to have a number of positions that produce short-term gains. In particular, whenever a call expires unexercised, the sale proceeds constitute a short-term gain. Similarly, when a call that was written is offset by a purchase at a lower price, the gain on the transaction is short-term for tax purposes. Finally, any stock that is sold at a profit after being held for less than a year gives rise to a short-term gain. All of these types of short-term gains are subject to ordinary tax rates. Investors in the 33%, 35% or 39.6% tax bracket will have to pay the Internal Revenue Service (a large percentage of any “net” short-term gains. And these gains may be subject to a state income tax liability on top of what the IRS takes. Long-term gains are also taxed, but at an appreciably lower rate (15% or 20% for most people). So the covered writer’s preferred tax strategy is to manage the portfolio in a way that allows them to offset short-term gains with short-term losses while deferring most net gains into the future. When gains are taken, they should, when possible, be structured to be long-term gains. So, one of the benefits of having a few positions where the stock rises well above the call’s strike price is that it allows the investor to harvest short-term losses by covering the short position in the calls with an offsetting purchase. Indeed, even in the case where the investor does not plan to continue to write calls on the stock, covering the short position in the call may be worthwhile. The investor can then sell the underlying stock and realize a long-term gain, while generating a short-term loss on the option side of the transaction.
The Stock’s Price Is Far Below the Strike Price
Fourth, the stock price could fall far below the level where it was purchased. The call would expire unexercised. But the decline in the stock price would be much greater than the sum of the proceeds from the call sale and dividend payments. And now the stock is trading far below its initial cost. Only writing calls on stocks with generous and sustainable dividend yields should limit the frequency of this type of result. But over time, it will happen. Once again, the investor should evaluate the stock for its covered writing potential. Is the dividend yield still attractive? If the firm has not reduced the dividend payment, the fall in the stock’s price should make the dividend yield even more generous than it was earlier. Quite often the same factors that caused the stock’s price to drop also led the firm to reduce or eliminate its dividend. Even if the dividend has been maintained, its future may be in doubt. A substantial stock price decline usually indicates a negative market outlook for the company. So, in many cases where the stock price has gone down substantially, the investor may no longer find the stock to be attractive for covered writing.
In a few cases, however, the stock may still fit the criteria. That is, it may have an attractive dividend yield that is viewed as unlikely to be reduced and the stock itself may offer some upside potential. If so, the investor may want to retain the stock and write a new option once the old option expires. That raises the issue of what level and length of option to write. Because the stock’s price has fallen substantially, writing an option with a strike near the stock’s current price risks having the stock called away for a price that results in a loss to the investor. An option with a strike price at or above the stock’s cost may trade at such a low price as to be hardly worth the effort. It is hoped that most of the writer’s covered positions fall into one of the first three outcome categories.
There is one type of maneuver that may sometimes be worthwhile in the above situation. Suppose the stock that experienced the large drop is one that the investor is still relatively optimistic about. In that case, the investor may want to retain an interest in the stock, but not write a call on it with a strike near its current price for fear of having it called away. They could sell the stock and simultaneously write a deep in-the-money put option on it (the opposite of a call).
For example, say, an investor purchases stock at $35 only to see its price fall to $25. He sells the stock at $25 for a loss of $10. If the stock can be sold before it has been held for 12 months, the loss on it will be short-term. He then writes a put on the stock with a strike of $35. (A put gives the option contract holder the right to sell the stock to the option contract writer at the strike price.) If the stock is then put back to the investor when the put reaches its expiration, the investor will have his position restored. There are three benefits from this set of trades. First, the sale of the stock and writing of the put option will generate cash that can be invested elsewhere. Second, the stock sale will generate a capital loss that may be short-term. Third, to the extent that the put sells for more than its intrinsic value (called its time value), the investor captures this sum. In an ideal world, the stock rises at least part of the way back to its original cost and the investor captures that when the put is exercised. At that point a new call can be written.
Adjusting a Covered Call Position
Now let’s consider the possibility that the investor may wish to adjust a covered position before the option reaches its expiration date. Such an adjustment may be forced by the prospect of an early exercise by the option’s owner. Option holders are only likely to exercise early when doing so is to their advantage.
Most of the time, the option holder is better off either selling his or her option or waiting until just before expiration to exercise it. If the option is out of the money, exercise makes no sense. Anyone who wants to own the stock can purchase it at a lower price in the open market. And if the option is in the money, selling it is more attractive when, as is usually the case, the option’s market price exceeds its intrinsic value. Options that trade below their intrinsic value set up an arbitrage opportunity that is not supposed to happen in a truly efficient market. Nonetheless, options are occasionally quoted at prices equal to or even a bit below their intrinsic values. For example when a stock is about to go ex-dividend, the quoted call price may fall slightly below its intrinsic value, in which case early exercise becomes advantageous. Such a below-intrinsic-value price is particularly likely when the call is deep in the money and expiration is close.
When a company declares a dividend, it establishes the day that determines who receives that dividend, called the day of record. Those who are recorded as owning the stock on that date will be paid the dividend even if they sell their shares before the checks are sent out. Because settlement of trades takes three business days, one must have purchased the stock three or more days prior to the day of record in order to receive the dividend. The first day after the last day for owning the stock and being paid the dividend is called the ex-dividend date. The stock’s price will typically fall on its ex-dividend date by about the amount of the dividend. So in the case of AT&T Inc. (T) with a dividend of $0.46 per quarter, the stock price will tend to open about $0.46 lower on the ex-dividend date than it closed at on the day before.
Those who trade options need to keep an eye on ex-dividend dates of stocks on which they have written options. If the owner of a call chooses to exercise the option just before the ex-dividend date, they will thereby capture the dividend. If they let it pass, the covered writer will receive it.
If an option is selling close to what is called its intrinsic value (the amount by which it is in the money), and the ex-dividend date is near, early exercise is quite possible. This circumstance presents the covered writer with a choice. On the one hand, the writer can simply take a chance that the call will not be exercised early. Allowing the exercise to proceed will still produce a profit for the covered writer. But that may not be the best outcome. If, for example, the stock has been held for less than a year, the short-term gain on the stock will be taxed at the full ordinary income tax rate. Moreover, the covered option writer may wish to retain the shares for continued option writing. Accordingly, the investor may prefer to buy back the option just before the ex-dividend date and simultaneously write a new option. This process of buying an option to offset the short position and writing a new option to replace it can be implemented sequentially. Such a two-step set of transactions is called “legging on.”
In the appendix to this article, I discuss another alternative, a spread trade that implements two trades together.
If the stock has already increased to a level above the strike price on the existing option, to write a new out-of the-money option would require the option to have a strike price above that of the option position that is to be extinguished. The spread order would be set at a net price that takes into account both the price paid to extinguish the old option and the proceeds to be received from writing the new option. Depending upon specifics, the net amount could be either a credit or a debit. If the two strike prices are relatively close together and if the new call is to be written for a relatively long period, then the investor may obtain a small credit. Otherwise the trade is likely to result in a net debit.
The option traders who implement option orders for their brokers know how to execute these spread trades effectively. To understand why accomplishing this set of transactions as a spread rather than legging on is often advantageous and brings up the issue of the bid-ask spread (the difference between the bid and ask price on the option). This bid-ask spread is generally incurred as part of the transaction costs of buying and selling.
Most securities, including options, are bought and sold in a market where buyers are continuously offering to buy and others are offering to sell at pre-specified prices. The highest current offer to buy a security is called the bid and the lowest offer to sell is called the ask price. At any particular time, the ask price will be at least some amount above the bid. So, for example, a call might be priced with a bid of $3.50 and an ask of $3.75. That would reflect a bid-ask spread of $0.25 ($3.75 – $3.50). Note that option prices are almost always well below the prices of their underlying stocks, whereas their bid-ask spreads tend to be higher than those for the stock. As a result, the bid-ask spread on options tends to be a much larger percentage of the option’s price than the bid-ask spread on the stock.
In the situation described above, both the option to be bought (to cover the short call position) and the one to be sold (to write a new option) would be quoted with a bid-ask spread. If one uses a market order to leg on to the two positions, that bid-ask spread will be incurred on both trades. If, however, the investor instructs the broker to work the transaction as a spread trade, the result will generally be a better overall price. If the bid-ask spreads are wide, using a spread trade is probably indicated.
Having obtained the current bid and ask on the two options, one can now consider how to enter the trade. In the worst case, the trade would be assembled by paying the ask for the option to be bought and being paid the bid for the one to be written. This is the result for one who legs on using market orders. In the best case, the to-be-purchased option would be bought at the bid and the one to be written sold at the ask. This is the very unlikely result of trading at the best currently possible quotes for both options. Put another way, the worst result would cost the investor the sum of the two bid-ask spreads, whereas the best result would have the investor pay none of the bid-ask spread. A realistic result would be between these two extremes.
To set up a spread trade, the investor would need to specify a combined price between the best- and worst-case numbers. That combined price would reflect the net impact of the purchase and sale. If the call to be purchased costs more than the one to be written, the combined price would be the difference in the form of a debit. An example will illustrate this process.
Suppose the option to be extinguished was being quoted at $3.50 bid and $3.75 ask and the one to replace it at a higher strike price with a further off expiration was quoted at $2.10 bid and $2.30 ask. In the worst case, the trader would pay $3.75 to extinguish the short position and receive $2.10 for writing the new option. That would create a net debit of $1.65 ($3.75 – $2.10) for the two trades. In the best case, the investor would pay $3.50 and receive $2.30 for a net debit of $1.20 ($3.50 – $2.30). In this example the best result, a debit of $1.20 would be $0.45 less than the worst result, a debit of $1.65. Clearly, if a spread trade can significantly improve the outcome, the investor is well advised to do so. Implementing a spread trade does, however, involve an element of strategy. A debit of somewhere between $1.65 and $1.20 would be a logical place to try to implement this spread trade. The more aggressive the number, the less likely is its execution. If one seeks to trade at a net debit of $1.65, execution is virtually assured. Trying to trade at $1.20 is almost certain to fail. Realistically, the best place to try is somewhere between the midpoint of the two numbers and the highest cost number. In order to try to execute your spread trade, your broker is likely to enter an order for one part of the trade at a favorable price level and if that order is successful, quickly execute the other side at a price that yields a net result in line with your instructions. In the above example, the midpoint is at $1.425. So entering an order for a trade in the range of $1.65 to $1.43 has a reasonable chance of success. One might tell the broker to work the spread at a debit of $1.45, which would be $0.20 better than legging on. The broker’s option trader might then enter an order to cover your short at $3.50, which is the bid level. If that order is executed, the trader can then write the other side of the trade at the bid of $2.10 for a net debit of $1.40. As the markets fluctuated, the trader would adjust his or her quotes, but always in a way such that if one side of the trade is executed, doing the other side with a market order will complete the spread at a price within the specified levels.
Another possibility for exercise involves the finer points of option trading. The last day for trading options is generally the third Friday of the month. Options can, however, be exercised on the Saturday that follows that third Friday. Thus even if the option does not close in-the-money on the last trading day, it may still be exercised after the close. A couple of situations can lead to such an outcome. First, news that is likely to affect the value of the underlying stock (earnings announcement, takeover offer, regulatory action, etc.) may be announced after the market’s Friday close. When that happens, those holding unexercised options may believe that the news will cause the stock to trade on the following Monday at a level that would allow a profit from an exercise. Second, some trading continues after the market closes on the exchanges. If the stock price moves either up or down after the close, some out-of-the-money options (puts or calls) may move into the money. Thus, those who own these options may choose to exercise them.
Often the underlying stocks trade very close to one of the key option pricing points just as they are about to expire. The buying and selling in the market that may push the price close to this price level in a process is called pinning. If many options are outstanding at, say, a strike price of $50 and the stock price begins the day close to $50, many investors may be long or short the options while seeking to exit their positions with offsetting trades. Those with exchange seats may only be willing to take the other side of the trade if they can do so at a guaranteed profit. This process will tend to drive the prices slightly below intrinsic values for in-the-money options. The exchange members can then take advantage of the situation by buying the calls selling below their intrinsic value and immediately exercising and selling the resulting stock. So, for example, if the call is in the money by $0.05 but selling for $0.03, one with a seat on the exchange could purchase the option, exercise it and simultaneously sell the stock for a profit of $0.02 per share less the cost of the trades. Exchange members pay almost nothing to execute a trade. This process, however, would add selling pressure to the stock, driving its price down toward the call’s strike price ($50). If, however, the puts were slightly in the money and trading for less than their intrinsic values, a similar process would drive the price of the underlying stock up toward $50. As a result, the stock is likely to trade near closing and close at or very close to $50. After close, those left holding a long position in the options would look for an opportunity to extract value by exercising whenever they could trade in the after-market profitably. The upshot of the above discussion is that exercise after option trading has ended on the expiration Friday is still a real possibility for options whose stocks close at or close to their strike price. To avoid such an exercise, call writers may want to cover their short option positions whenever the underlying stock is trading close to the option’s strike price near expiration. In such circumstances, the options will generally trade for no more than a few pennies.