For covered call writers the main stock option strategy is to purchase an equity specifically for the purpose of selling the corresponding call option. The investment time frame is one to two months as earnings reports will end the “run” of even the best performing equities (if you agree with my guidelines). In many cases share assignment is permitted by the seller and even if early assignment occurs, our investment would still have been a successful one. In other words, losing (selling) the stock is no problem and really just part of the strategy.
There are other investors who sell call options in a different manner, called portfolio overwriting. In this instance, a call option is sold on a stock already part of an existing portfolio. That option is selected in a manner where it is NOT expected to be exercised. Remember that you need to own 100 shares for every options contract sold.
Why a Portfolio Overwriter does not want his shares assigned:
This is basically a tax issue. The holding period for short-term versus long-term capital gains is one year. If the stock has been held for less than that time frame, the writer would prefer to retain the equity for a longer time frame. In addition, if the shares have appreciated substantially from the cost basis, selling in any time frame may not be in the investor’s best interest.
Another important tax issue:
If the underlying stock has not accumulated the full 1-year holding period for long-term capital gains, covered call writing may suspend or eliminate the current accumulated holding period. It is advisable to consult with your tax advisor on this matter.
Advantages of portfolio overwriting:
- Achieve higher returns in declining, neutral and slightly bullish markets
- Beat the returns of long-term holders of equities
- Increase portfolio downside protection, thereby minimizing risk
- Generate a monthly cash flow
- Use option profits to compound your money
Strike selection for portfolio overwriting:
Since our goals are to generate a monthly cash flow and NOT have our shares assigned, common sense dictates that we sell out-of-the-money strikes. This will benefit us in that time decay is greatest for these strikes and option value will dissipate as we get closer to expiration Friday. Remember, we don’t want our option strike price ending up in-the-money (lower than current market value of the stock). Our mindset needs to be slightly different when selling these OTM strikes in that a 2-4%, 1-month return is too lofty a goal. I would set it more at 1-1 1/2% per month, ensuring that the implied volatility of the option is not too high. A high IV means that the market is anticipating a large price movement and that increases the possibility of the option ending up ITM. So settle for a lower premium and therefore less chance of assignment. As a guideline, I like to see the share price at least 5% lower than the strike sold. As an example, if I sold a $50 strike, I would want that equity to be currently trading @ $47.50 or less, with the option premium generating 1 to 1 1/2% for the month. Let’s look at the options chain below for GMCR, one of the stocks often found on our premium watch list :
If the share price remains below $40 by expiration Friday (the third Friday of the month) no action is needed on your part and you’re free to sell another option the next month. If the share price is above the strike price ($40) you can roll the option (buy it back and sell the next month option). If you need cash to buy back the options and don’t have it in your account, you can sell enough shares to buy back the options and retain a majority of the original shares. In keeping with our cash allocation and portfolio rebalancing requirements we would tend to sell shares that have appreciated the most and have a dominant position in our portfolio.
Why some portfolio overwriters sell ITM strikes:
This is a riskier strategy if keeping the stock is important to the investor but there is a case that can be made for it. It is generally used when the stock or market in general is declining and the ITM strikes will generate greater returns with more protection. Also, the higher delta of the option (amount the option changes with a corresponding $1 change in the stock price) will make it easier to close or roll the position (buy back the option). Investors also use the ITM approach in conjunction with technical analysis where support and resistance points are identified and ITM strikes are sold at resistance and closed or rolled if still ITM near expiration Friday.
What if early assignment occurs?
This will not occur often but it could eventually happen. In these cases, purchase an amount of shares equal to the obligation to deliver and notify your broker that these newly acquired shares should be indentified as the shares delivered to meet the option obligation. Check with your broker, before the fact, as to the best way to manage such scenarios.
Portfolio overwriting provides many of the advantages of the buy-write strategy but because of tax implications, income goals and strike management differ and need to be fully understood before taking action.
Next live event:
American Association of Individual Investors- Milwaukee Chapter
Winter Retreat Meeting
Saturday January 19th 7:30 – 2:30 (I am one of 5 speakers with a 1-hour presentation)
Westmoor Country Club
Detailed information to follow
- Housing has become a strength as manufacturing has weakened while our economy continues to recover at a snails pace. here are this week’s reports:
- Construction spending in October rose by 1.4%, much better than the 0.5% expected
- Non-farm productivity (A measure of the growth of labor efficiency in producing the economy’s goods and services) was up 2.9%, ahead of the anticipated 2.7%
- The ISM Manufacturing Index (An indicator of overall factory-sector trends, based on a survey of purchasing managers at several hundred manufacturing firms in a variety of industries. An index reading above 50 indicates that the manufacturing economy is generally expanding; below 50, that it is generally declining) was reported @ 49.5, below expectations
- Factory orders for October rose by0.8%, better than expected
- The unemployment rate fell to 7.7%, much better than the 8.0% anticipated
- Initial jobless claims came in at 370,000, better than expected
For the week, the S&P 500 was up 0.1% for a year-to-date return of 15%, including dividends.
IBD: Market in a confirmed uptrend
BCI: This site remains bullish on our economy but extremely cautious in the short term. Until the “fiscal cliff” issue is resolved positively we are establishing our positions with securities that have low implied volatility (low beta stocks and ETFs) and in-the-money strikes for additional downside protection.
My best to all,