Option Writing Strategies

Option Writing Strategies By Ben Branch February, 2014

Call Writing • Write calls on stock position • Three potential sources of income • 1) Proceeds from sale of call • 2) Dividends received on stock • 3) Some price appreciation if call written out of the money (strike price above cost of stock) • Together, these sources can produce attractive returns

Covered Call Illustrated

An Example: AT&T • Stock Price: 32.30 • One year call with strike of 35 priced at .78 • Dividend rate: 0.46 per quarter or 1.84 annually • Potential profit: .78 + 1.84 + 2.70 (35 – 32.30) = 5.32 • Potential return: 5.32/31.52 = 16.88%

Risks • Stock price could fall by much more than the proceeds from the sum of the call sale and dividends received. • Stock price could rise by far more than the amount received from the call sale and dividends (opportunity cost)

Possible Outcomes • Stock rises up to or above the call’s strike price • Return = 16.88% (Maximum gain) • Stock stays at the same price as it cost: Profit = .78 + 1.84 = 2.62 • Return = 2.62/31.52 = 8.3% • Stock falls to break even price level • 32.3 – 2.62 = 29.68 • As long as the stock stays above $29.68, the position shows a profit

My Assumptions • Our low interest rate environment will continue for at least a couple more years • The US economy will continue to grow at a moderate rate • Given the above, selective covered writing is attractive

Implications • Companies which pay relatively attractive sustainable dividends will generally hold their values over time. • If such companies experience growth in their revenues, profits and dividends, their stock prices will tend to rise. • Such companies are attractive candidates for covered call writing.

Implications II • A diversified portfolio of covered calls on carefully selected stocks should produce attractive returns over time • When the market is strong, the portfolio would underperform the market • When the market is weak the portfolio would outperform the market • When the market is directionless, the portfolio would outperform the market

Assembling the Portfolio • Identify a diversified group of companies with attractive characteristics for call writing • Generous dividends (above the average yield on the S&P Index and above the 10 year government rate) • Sustainable dividends (good coverage from earnings, relatively stable earnings history) • Strong strategic position: large share of stable served market, strong brand identification, adequate capitalization • Some growth potential (history of past growth, stock buybacks, appreciable spending on R&D and plant and equipment)

Examples • Stocks in the Dow Jones Industrial Average • Particularly the “Dogs of the Dow” • “Dividend Aristocrats” of the S&P 500 • Particularly those with current dividend yields above 3% • Quality stocks rated A with current yields above 3%.

Which Calls to Write • Write calls with expiration a year off so that by the time the call reaches expiration, the stock will be held long term • Select strike a bit above the current stock price so that the position can capture some price appreciation if it occurs

Four possible Outcomes at Expiration • 1) Stock price slightly above strike price • 2) Stock price slightly below strike price • 3) Stock price much above strike price • 4) Stock price much below strike price

Stock price slightly above Strike • Maximum return already earned • Question: Should stock position be preserved so that a new call can be written against it? • Reexamine stock for suitability for covered option writing • If determined to be suitable, cover short call position with an offsetting purchase • Otherwise exit position

Write New Option • Stock holding is now long term • If sold, tax will be at long term rate • Transaction costs of purchasing stock already incurred • So now may write shorter term calls against stock positions • Allows expirations to be spread out over time thereby providing greater flexibility

Stock Price Slightly below Strike • Again, check stock for suitability for further covered call writing • Short calls will expire worthless • Proceeds from their expiration are short term gains as sale preceded expiration. • Write new calls if stock determined to be suitable for such • Otherwise sell stock

Stock Price Much above Strike • Again check if stock is suitable for further covered writing • Regardless of suitability, cover short position in calls in order to create a short term loss for tax purposes • Write new option if stock suitable • Otherwise sell stock

Stock Price Much below Strike • Again check stock for suitability for covered call writing • May sell stock just before it becomes long term holding • Or retain stock and write new covered call on it. • Or sell stock and write put equal to the number of shares sold

Legging on verses Spread Trading • If the old short call is to be covered by an offsetting purchase and replaced by a new call, the process can be done in one of two ways • With legging on, the investor first buys the offsetting call and then writes a new call with a more distant expiration • With a spread trade, the two parts of the transaction are implemented together

Spread Trading • Spread Trading is attractive when the options are quoted with wide bid ask spreads • The investor specifies a desired net outcome from the two trades and the option desk attempts to implement the transaction • Generally one would specify a net outcome which would reflect paying about a bit more than half of the combined spreads

Spread Trading: Example • Bid/Ask on option to be bought: 3.50/3.75 • Bid/Ask on option to be sold: 2.10/2.30 • Worst case (legging on result) buy at ask (3.75) and sell at bid (2.10) for net debit of 1.65 • Best case buy at bid (3.50) sell at ask (2.30) for net debit of 1.20 • Realistic attempt to trade at debit of 1.45, midway

Possibility of Unwanted Early Exercise • Option exercise is a choice for the option holder • The writer needs to analyze the possibility that the option holder will choose to exercise • If call is out of the money, better for long to buy stock without option • An in the money option will usually sell for more than its intrinsic value in which case selling the option is more attractive than exercising it • Accordingly, early exercise is usually unattractive for option holder

When Early Exercise Becomes Likely • Options which are deep in the money close to expiration and about to go ex-dividend may be attractive to exercise • When a stock goes ex-dividend, its price tends to drop by about the amount of the dividend • To capture the dividend and thereby offset the impact of the expected price drop, the option holder may exercise just before the ex date

Why the Investor may prefer to avoid an early exercise • If the stock had not yet been held long enough to qualify for long term gains tax treatment • If the investor plans to cover the short call position in order to write a new option on the stock • So when early exercise looks likely, the investor may want to offset the short call position by purchasing an equivalent call before it is exercised

Saturday Exercise • The last trading day for options is the third Friday of the expiration month • The last day for exercising options is the following Saturday • Sometimes a stock may close at or very close to the strike price on a call which is set to expire • Even though the call is not expiring in the money, it still may end up being exercised if news after the close suggest the price will be higher on the following Monday

Pinning • The reason why stocks often migrate to a particular strike price level at expiration relates to the activity of those who trade on the option exchange floor • As options approach expiration, their quote tends to fall to their intrinsic value and often a bit below that level • Traders on the exchange can then make a small profit by purchasing the option below its intrinsic value exercising and then selling the stock • This process tends to drive the price toward the strike price • If the strike on the investor’s short call is near the level of the pinning, exercise is likely

Avoiding Last Minute Exercise • To avoid the possibility of an unwanted exercise the investor needs to be mindful of the possibility • Closely monitor calls on stock that are about to go ex-dividend when the calls are deeply in the money and close to expiration • Also be careful with calls that are trading close to their strike near expiration • Cover short call positions when an unwanted exercise seems likely

Writing Covered Straddles • A Straddle is a combination of a put and call with the same strike and expiration • Writing a covered straddle involves taking a short position in both a put and corresponding call on a long stock position • Put another way it is the same as adding a short put position to a covered call position • The result has more upside and greater risk than a simpler covered call position

Short Put Illustrated

A Short Put is Similar to a Covered Call • Similar payoff structure • Differences • Covered call costs more • Covered call receives dividends • Short put requires margin • Short put has tax disadvantages

Covered Short Straddle Illustrated

Conclusion • If we are indeed in a low interest slowly recovering economic environment, covered call writing on stocks with generous sustainable dividends should produce attractive returns, particularly if the selected stocks have some potential for price appreciation • Writing covered straddles may be even more attractive but involves significantly greater risk

Option Writing Strategies