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Questions on covered calls
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Rashid
08-23-2008, 6:38 AM | Post #2553312 |
13 Replies
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I want to do a Buy-Write on a stock. So I want to buy say 100 shares of X at price of $45. And at the same time sell a call with strike of $46 for $4. Let's get commissions out of the way for easy calculation. My cost to own 100 shares of X = $45 * 100 - $4 * 100 = $4100. Questions 1) When I get called, I have to deliver my 100 shares to the caller at $45. So I get my $4500 back. So I made $400 on the premium I collected. Is this correct?
2) Can I get called even if stock price never reaches the strike price of $46? 3) Can I get called at any point before expiration or only at expiration?
4) While I would think it is foolish for the call buyer to ask for delivery of the stock of the stock dropped to say $42, the buyer of the call may simply sell the call to someone else since it has dropped in price and he wants to protect his losses. In that case, am I involved in this in any way? Or does the caller sell his depreciating call to someone else in the market and I assume I don't even care any more who actually holds the call I originally sold? 5) Same scenario as above, but for some reason the call buyer actually wants delivery of the stock even when price is $42. I will still only have to honor my promise of delivering stock at $45. So I still get $4500 for my stock and still will have made $400 on the premium I collected. Is this correct? 6) After I execute my Buy-Write at my broker, do I have to do anything actively when my stock gets called? Or does the broker take care of delivering my stock to the caller, charging me commission and then simply notifying me of it? Just want to make sure I cannot lose money if I get called because I forgot to do something. I'm simply trying to see if I can generate some income better than what I can get on a CD at my bank. I realize that if the stock drops in price there is no surefire protection for my money beyond the $400 I collected as premium, i.e. beyond $41 for the stock price going down. I also realize that I don't think I'll be to collect that much premium - $4 - on a strike price just $1 away from the price I paid. But I just wanted to make sure I got everything right before I actually experimented a little. Don't want to lose my shirt just because I misunderstood how things worked. Thanks in advance for any help.
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Re: Questions on covered calls
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merjet
08-23-2008, 12:29 PM | Post #2553414
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The following numbers correspond to yours.
1) You'd get $4600 if the strike is $46.
2) Who would want to buy shares from you at $46 when the market price is less?
3) "American" options may be called at any time, and "European" options can only be called at expiration. "American" and "European" are not about where the options are traded. Most traded options are American.
4) No and yes.
5) See my answers to 1 and 2.
6) Your broker should handle it.
The $4 price you used is plausible. The price much depends on the time to expiration and volatility. There are plenty of option price calculators on the web, such as here:
http://www.cboe.com/LearnCenter/OptionCalculator.aspx
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I still have a lot to learn
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Rashid
08-24-2008, 7:07 PM | Post #2553784
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Thanks for responding! If it is indeed possible to get $4 for 1 call with roughly the same stock and strike prices, that's like a 7% return over 6 months. Sounds too good to be true. Of course, needless to say the stock could tank. But if it's a stock I don't mind holding for a while, seems like worth the effort for me to explore further. Thanks again.
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Re: I still have a lot to learn
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duanej
08-24-2008, 7:52 PM | Post #2553796
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Covered calls are certainly legit, and probably one of the best ways to use options. Here's an example. Cemex closed last Friday at 20.62/sh. You could buy the shares and then write a Jan10 Call at a strike of 30, and collect $1.80 in premium. On an annual basis that's about 6% coming in from the option premium, and you only get the shares called away if the stock jumps nearly 50% in the next year and a half. Not a good idea on shares you've held for a long time that you want to keep holding, though. This could force you into realizing a capital gain when you don't want to. Regards, Duane
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Rashid
08-24-2008, 8:33 PM | Post #2553809
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Thanks for that response. I hadn't considered taxes at all. I presume if I get called then I will pay taxes on the difference between my buy price and the strike price. But what happens to the premium I collect? Is it income? Or is the premium also taxed as short / long term capital gains depending upon how far off the option is expiring?
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duanej
08-24-2008, 8:53 PM | Post #2553818
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Yes, the capital gain would be the difference between your sale price (strike price in this case), and your purchase price. I believe option premiums are treated as ordinary income, but not sure. I don't use options, but have considered covered calls. This would be best to carry out in an IRA, as it's not a very tax-efficient form of equity investing. Regards, Duane
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Rashid
08-25-2008, 7:01 AM | Post #2553877
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Okay, so I thought option trading was not allowed in IRAs because of their "riskiness". I guess covered calls are allowed in IRA because they are "riskless" in that you cannot lose more than what you would if the stock you had dropped. As you say regardless of how premiums are treated, its not a very tax efficient way. However, if I'm chosing to use this strategy as a replacement for buying CDs, then I guess it would be worth it. I had some money at Izone from TD Ameritrade where the commissions are quite low. My IRA is at Scottrade and the commissions there are quite high for option trading. But I'll surely give it a look. Thanks for everything.
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merjet
08-26-2008, 8:38 AM | Post #2554204
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The investments not allowed in an IRA are collectibles and life insurance.
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duanej
08-26-2008, 10:38 AM | Post #2554242
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I don't know about other options positions, but I'm pretty sure covered calls are allowed in an IRA. Certainly anything that could result in a margin call is not allowed. Yes, keeping the costs down is important. If the commission is eating up a big chunk of the option premium, it's not worth the effort. Regards, Duane
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A slight addition to the earlier response for #2, a holder of a slightly-out-of-money option may choose to exercise it early if it would capture a dividend or a spin-off. Their sunk cost for the call, exercise and commission costs, and value of the dividend or spin-off may make it profitable to them to exercise the option instead of selling or expiring the option and buying new shares at market.
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Rashid
08-26-2008, 10:55 AM | Post #2554248
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After Googling, I conclude that all gains from covered calls are taxed as ST capital gains and not as income. I'll confirm looking at IRS publications some time. Right now its not terribly important. I am put in 3 experimental trades with around $6K capital. I've bought MSFT, ORCL and RMBS 100 shares each and sold 1 call each expiring Mar/Apr 2009 depending on the stock. I'm playing the "tech does better in 4th quarter" theme. Dunno what else can go up at this point. RMBS is a little aggressive but my strike is very close to my buy price. In fact my MSFT and ORCL positions are also quite close.
I would like to share this portfolio in M*. Unfortunately, the portfolio does not allow Sells to be tracked. That's a bummer. It would have been a good thing to share and learn from others. If I'm wrong and anyone know how to track Call sells in M* transaction portfolio, please let me know. Given M* has started an Options and Derivatives chapter, I'm surprised they haven't thought of an easy way to track options in portfolios. So I'm hoping I'm wrong and someone will set me straight. Thanks in advance.
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duanej
08-27-2008, 2:08 PM | Post #2554598
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Re: Questions on covered calls
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billjam
09-03-2008, 10:44 PM | Post #2557608
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Covered calls are definitely allowed in IRAs. I use them in my Fidelity IRA account. Remember that while you may generate a nice boost to income, there is a large principal risk. While the call is in effect you must hold the stock. So if the stock drops, you can't sell it without buying back the call. Of course the lower stock price will result in a lower price to buy back the call, but probably not enough to cover your loss on the stock. So only do this with short term calls or a stock you'd be comfortable holding long term if it declines in price.
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Re: Questions on covered calls
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InvestorDiv
09-04-2008, 3:36 PM | Post #2557905
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