When we sell a covered call option, we are undertaking an obligation for which we are well paid. Should the option holder decide to exercise that option, we must sell our shares at the specified strike price at or prior to the expiration date. This is the nature of American style options as opposed to European style options.
American style options: an option contract that may be exercised at any time between the date of purchase (sale) and the expiration date. These are the options that we, as CC writers, deal with.
European style options: an option contract that can only be exercised on the expiration date.
For the most part, share assignment will not occur until after expiration Friday when the agreed upon strike price is below the current market value. For example, if we sold the $50 strike and the current value of the stock is $52, the option holder or brokerage will exercise that option and achieve a $2 per share profit.
Why aren’t most options exercised early?
Option value consists of intrinsic + time value. Early exercise will result in the holder surrendering this time value, so it rarely occurs. The option owner may sell the call to capture the time value but early exercise and purchase of our shares does not make sense if there is significant time value remaining ($0.25 or more). It’s true that the shares can be purchased and then sold at market to capture this value but why not just sell the call? This concept applies to I-T-M and at or near-the-money strikes as O-T-M strikes would never be exercised.
How is it determined which shares are assigned if early assignment?
This is a completely random process whereby the Options Clearing Corporation (OCC) decides to which brokerage the assignment will be given and the brokerage will then pass it on to one of its clients.
Why does early assignment occur?
As time value declines (below the aforementioned $0.25), the chances of early assignment increases. There are times when the calls trade below the intrinsic value and in these cases the chances of early assignment are much greater. This will occur when the strike is deep I-T-M. Let’s look at the options chain for VIT, as an example:
Note that the intrinsic value of the $12.50 call is @ $3.25 (since the stock price is $15.75) and yet the bid or our sale price of the option is $3.10 (red circle). Not only is there no time value for this option but it is actually trading below the intrinsic value. The last sale was @ $3.25 which is actually the exact amount of intrinsic value. The $15 strike, on the other hand, has time value of $0.35 ($1.10 – $0.75). As your strike moves deeper I-T-M, the chance of early assignment increases.
Other factors that may lead to early assignment:
1- Dividends- When your equity is about to distribute a dividend, early assignment is possible for I-T-M strikes when that dividend value is greater than the time value remaining for that option. This will take place prior to the ex-dividend date or the date share ownership is required to be eligible to capture this dividend. Here is a link to a FREE site that tracks these dates:
http://www.dividendinvestor.com/tracker.php
2- High Open Interest- When you see thousands of open contracts we know that the institutional players are involved. Their trading costs are near zero and their arbitrage opportunities are greater than ours when time value approaches zero.
3- Pinning the strike- when puts and calls are near the money on expiration Friday, there is a tendency called pinning the strike for the stock to move to the strike price or slightly beyond. This may result in assignment (not early, but unexpected) after the bell. This can also take place if there is a report or late news coming out the day of expiration.
How to avoid assignment:
1- To generate more cash (mid-contract) - If there is little or no time value remaining in our option (sold) why not unwind our position? B-T-C the call and sell the stock thereby re-capturing the time value. Now take that bundle of cash and re-invest it in another CC position. You can also roll the call out or up and out if the calculations are favorable. Remember, CC writers are tough “bosses”. No vacations or days off for our cash. They are put to work at all times during normal market conditions.
2- To avoid tax consequences- If your cost basis is much lower than the current market value of your shares, assignment may result in an unfavorable tax consequence. In these cases, you will want to close or role your calls before assignment. If your shares are unexpectedly assigned, you can purchase new shares at market and inform your broker that these new shares are to be the ones associated with the assigned option. Please check with your tax advisor and brokerage on these matters.
Conclusion:
Early assignment of your shares is rare but possible. Understanding why and when it may occur will further add to the bottom line of your investment success.
Market tone:
A mixed but encouraging overall picture was painted by this week’s economic reports:
- Non-farm payrolls increased by 244,000, much higher than expected, due to private sector job expansion
- Unemployment unexpectedly bumped up to 9.0% due to the increasing number of people looking for jobs after having previously given up
- Private residential construction rose by 2.6% in March
- Orders for manufactured goods increased by 3.0%, beating expectations
- The ISM’s nonmanufacturing index, however, fell by 4.5 points disappointing analysts
- Non-farm business productivity was up 1.6% for the quarter, less than expected. Some analysts feel that this will lead to more hiring
For the week, the S&P 500 was down by 1.7%, for a year-to-date return of 7.2% including dividends.
Those who follow the market on a daily basis don’t need me to tell you how volatile the market has been of late. I have created two charts: one of the S&P 500 and one of the CBOE Volatility Index (investor fear gauge). Each is a 3-month chart. First the S&P 500:
S&P 500 as of 5-6-11
Note the following:
- The red arrow shows an overall 1.5% increase over the past 3 months
- The blue arrows show uptrends
- The green arrows show price declines
Now the VIX:
The VIX as of 5-6-11
Note the following:
- The red arrow shows an overall volatility increase of 15%
- The green arrows show volatility increases
- The blue arrow shows a calming volatility
Summary:
IBD: Market in correction
BCI: Cautiously bullish. Since September of 2010 I have been bullish on our economy as a result of favorable economic reports, bullish technicals on the overall market, calming long-term volatility and several quarters of positive earnings surprises. The cloud hanging over conservative investor’s heads is a result of the short-term volatility caused by global issues as depicted on the chart above. As a result, I am fully invested but including a high percentage of in-the-money strikes to serve as extra protection of my positions. I currently have 50% of my covered call positions with I-T-M strikes.
My best to all,
To all the Moms’
Wishing you a happy and healthy Mother’s Day. Let’s face it, we men would be lost without you!
Alan and the BCI team
Alan,
If the stock price rises leaving the strike price deep in the money, wouldn’t early assignment actually be a plus so the cash can be used to enter a new position?
Thanks.
Peter
Peter,
Yes you are absolutley correct but let me take your thought a step further. If the time value of the option premium approaches zero which is a characteristic of DEEP in-the-money strikes you can close your position at little or no cost and use the cash to establish a second income stream in the same contract month. I refer to this as the “mid-contract unwind”. I use this especially when there is at least 2 weeks remaining in the current cycle and I can generate significantly more income than the cost of closing. The point here is that you may not want to wait for early assignment which may or may not occur.
Alan
Alan,
How will wash sales rules affect me if I sell my stock at a profit, but I buy back the cc option at a loss, and then I sell another cc option on the same stock nest month? Thanks.
Premium Members,
The weekly report for the week ending 05/06/11 has been uploaded to the Premium Member site.
Best,
Barry
Alan,
This week there are 8 less stocks on the running list than the last 3 weeks. Is this because of the volatility you showed on this weeks article?
Thanks as always.
Barbara
Dan (#4),
The wash sales do not apply to your example. Selling a next month covered call, on the same stock, is not the same as selling the exact same call in the current month, which would be wash sale.
Here’s how it works.
You buy 100 XYZ at $38 and sell the Jun $40 call for $1.50. The stock rises and two weeks from now you buy back the Jun $40 for $2.50, for a loss of $1.00.
At this point, if you wait a week and sell the Jun $40, again, for say $3.20, you must adjust for the wash sale. You closed the Jun $40 for a loss and re-opened the SAME option within 30 days. The loss on the first trade will be added to the basis of the new trade. In this case, that means that your new $3.20 basis becomes $4.20.
If you closed out the Jun $40 call, and then sold the JULY $40 call, you would not have a wash sale. It is not the same, or even substantially the same, security.
I urge everyone to read the wash sale rules on page 58 of the IRS publication 550. It is important that you understand what is, and what is not, a wash sale.
http://www.irs.gov/pub/irs-pdf/p550.pdf
And, remember, the wash sale rules DO NOT apply to a GAIN. You can buy and sell the same stock 50 times in one day, and, if every sale is a gain, it counts. Wash sale rules only apply to a loss where you essentially re-enter the same position within 30 days BEFORE, or AFTER the loss date.
Also, there is a controversial decision out there, that I vehemently disagree with, and may be reversed, where the IRS treats a loss as a wash sale loss where you buy the same security in your IRA within 30 days. Don’t ask me how the loss is supposed to get recognized later. I don’t even think the IRS knows.
Barbara (#6),
The recent volatility definitely has impacted the screening process as whipsaws are created in the technicals that will cause certain equities to fail certain screens. You can get a specific read on the screening process by viewing page 2 of the report “Top-50 & Other–Failed One or More Screens”. This spreadsheet will show you precisely where each stock failed the BCI screening process.
Alan
For those who may want to speculate on a stock which is not on our list of the best of the best, or even the “so-so” of the best, the barely clinging to the “pretty good of the mediocre”, or the “wouldn’t touch it” group, Citibank is now $44. No, it did not suddenly gain 997%. They reverse split it 1 for 10.
Why is this important? Because most mutual funds cannot invest in stocks under $5. That’s not to say that won’t find its way back down to $5, but there is now a huge collection of available buyers out there that were not able to buy it last week.
Just a thought, NOT a suggestion.
BTW, my Netflix is turning out to be a good deal.
Alan,
What are your thoughts on using leveraged etfs with covered calls. Thanks.
Paul
Owen (#9),
What is BTW? I can”t find it.
Bill
Paul (#10),
Leveraged ETFs are NOT an appropriate investment vehicle for most retail investors. The returns oftentimes do not reflect that of the index they mirror. Most employ derrivatives and are rebalanced daily. Like all investments, it is critical we understand the ramifications of any security we invest in. Perhaps I’ll address this in more detail in a future article.
Bill (#11),
BTW = By the way (I, too, have trouble with abbreviations)
Alan
Paul (#10),
I posted a comment a week or two ago regarding how important it is for ETF buyers to understand the holdings of the ETF. Some of the ETFs are industry specific, so investing in one of them may not qualify as “diversified” when it comes to the BCI desire to not put all of one’s eggs in one basket. ETFs like SPY or QQQQ are good because they are index funds of general indexes. They will be hurt less by an industry meltdown, such as the one that the financial industry at the end of 2009.
The other consideration is, as Alan stated, the use of derivatives, or the use of leverage. Some of the funds even brag about their leverage by using terms in the fund title such as double or leveraged. The problem with them is that, like their ability to make money twice as fast as a similar fund without leverage, the leveraged fund can lose money twice as fast, too.
It is important that you search out the prospectus and other discussions regarding the fund you want to invest in. See what they invest in, and how they invest. When all else fails, ask on this blog. Someone will probably have an opinion.
Bill – I’m sorry. It did not occur to me that someone would plug BTW into a stock search. It should have, because we often don’t use the full company name.
Alan and Owen,
Thank you very much for your invaluable input. I’m really learning a lot from this site.
Paul
Anyone have any thoughts on FOSL? Its been on Alans list for 10 weeks and up 12 dollars today after the earnings report. Have I missed the boat?
Ted
For fans of OPEN I suggest you find a copy of yesterday’s Barron’s newpaper. They were VERY pessamistic about the company.
Ted,
I would wait a day or two and enter after the price settles. A good stock with a good earnings doesn’t frighten me.
Good luck.
Barbara
With the market so volatile lately do you prefer in the money or out of the money strike prices? How does this affect premiums?
Thanks.
Peter
Peter,
For most option traders, increased volatility is a friend because it inflates premium values. But for me and many other covered call writers enhanced volatility is a foe because of the risk associated with it. Today’s market action is a good example of that. To answer your questions:
1- For conservative investors, in-the-money strikes are preferable in volatile market environments.
2-Increased implied volatility will cause option premiums to increase in value. Asso0ciated with that, however, is the increased chance of a significant decline in share value.
Alan
hi Alan,
I received an email today about a software called “Volcone Analyzer 3.0″ and they claim that this software tells you if an option is cheap or expensive to but or sell. Out of curiosity, I searched for user reviews about this software (definitely thinking that this is some sort of a spam) but I saw good reviews about this and people actually thought this is helpful.
So I was wondering, what does it mean when they say buying/selling “cheap” or “expensive” options? As far as I know, in the BCI method, we simply base our decisions on the fundamental and technical analysis of the underlying and then go for ITM or OTM depending on the market and the ROO. Plain, logical and simple..Right?
hrkstox
Hrkstox,
Rather then address one of the specific option software programs, let’s look at option pricing in general terms. The most well-known and commonly used options pricing model is the Black-Scholes Model. It calculates the “theoretical” value of an option based on the following parameters:
■ The option’s exercise price
■ The current price of the underlying
■ The risk-free interest rate over the life of the option
■ The amount of time remaining until expiration
■ The volatility of the underlying
There are also( sometimes) inaccurate assumptions made like no dividends provided and European style executions but they play only a minor role in the pricing accuracy. The theoretical value is based on “historical” volatility of the underlying not the actual “implied” volatility of the current premium. If the IV is greater than the HV then premium will be greater for a call option and it will be said to be overpriced and vice-versa. Some believe that market forces will move that overpriced option down to it’s theoretical level.
If you are a proponent of this theory, it has greater application for more traditional options trading where you are buying and selling calls and puts. For covered call writing , we have already generated our option income and look to generate more through share appreciation if we sold an O-T-M strike. If an option is “overpriced” due to a high IV we will avoid that option if we deem it to be too risky. The guideline I use and have mentioned before is that if the A-T-M strike for a 1-month option is greater than 6% return (7% in a raging bull market) I will avoid it much like I should have avoided TASER many years ago. For me, it is not necessary to view option pricing models for covered call writing.
Alan
Alan,
When you say that half your options are in the money how do you determine which ones are in or out of the money?
Thank you.
Fran
Premium members:
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Alan and the BCI team
Fran (#22),
“Laddering” of strikes is more an art than it is a science. As a conservative investor I will favor in-the-money strikes in the following situations:
1- A slightly bearish or volatile overall market tone.
2- Mixed stock technicals
3- The stock will report earnings in the next cycle and I will want to sell the stock prior to the report.
The 50/50 mix I currently have can be accomplished by:
1- The strongerst stocks technically favor O-T-M strikes and the others I-T-M strikes.
2- When I have multiple options contracts with the same stock, I will do half of each.
3- Date of next ER may dictate as mentioned above.
Alan
CRR:
This stock on our premium watch list for the past 6 weeks had a stellar 1st quarter earnings report on April 28th. Revenues increased by 22% and earnings came in 27% ahead of expectations. CRR has boasted a 21% earnings surprise over the past 4 quarters. Cash and equivalents stand at $54M with no long term debt. Operating margin was at an incredible 60% during the quarter. There is also a bullish 29% growth projection.
A look at our latest premium watch list shows that CRR has an industry segment rank of “A”, a beta of 1.33 and has a dividend yield of 0.50%.
Check to see if this security deserves a place on your watch list.
Alan