Do you want to improve your investment skills? A covered call strategy might be a technique to increase your portfolio’s investment income while maintaining the long position
on the shares of stock you already own.
You don’t have to be an investment specialist to benefit from this option approach, but it’s a good idea to grasp the ins and outs of a covered call strategy before incorporating it into your options portfolio.
Covered Calls Basics
A covered call is a common premium income-generating options investment strategy in which you sell or write call options against shares of stock that you already own. When you write a covered call, you are offering someone else the right to buy the shares of a stock that you already own at a set price (called the strike price) and within a predetermined time frame.
Because a single option contract typically equals 100 shares, you must hold at least that amount (or more) for each short option call contract you want to sell in order to use this method.
You may be wondering why you would write covered calls. A covered calls options strategy is typically used by investors who intend to own their stock for the long term but do not expect a big move up of the price in the near future. Writing covered calls allows you to earn revenue from the premium while holding the stock since you pocket the premium immediately after selling (writing) the call.
And the fact that you already own the stock means you’re covered (thus the term) and, if the underlying shares’ stock price climbs to a higher price (over the strike price) and the call options are exercised, you simply deliver the shares that you already own.
If an option buyer chooses to exercise their option, the Options Clearing Corporation gets an exercise notice, which starts the assignment process to the covered call writer. The assignment is at random, and if you have a short options position, your brokerage firm may assign you.
How to Manage an Open Covered Call Position
When the expiration date of a covered call approaches, we normally want the price of the stock on which we are trading covered calls to be flat to marginally higher. There would never be a need to close covered calls early in an ideal world. Our short call options would all expire worthless, and we wouldn’t have to worry about the problem.
If the stock price rises too much, we have lost a possible profit on the shares of the stock by selling the call, and if the price falls too far, we have an unrealized loss on our stock position. On expiry day, in an ideal world, the stock would close slightly below our call strike. Unfortunately, the world is not perfect, especially when it comes to stock markets.
Closing a covered call position early, on the other hand, isn’t always a negative thing. In reality, in some cases, it may assist you either lock in the majority of your potential gains ahead of time or utilize it as an option adjustment approach to help control the risk on your trade.
In most circumstances, traders will need to take action on or near the expiration date, and in some cases, much before that. If you’re serious about writing covered calls, the question isn’t whether you should close a position early, but rather when to close a covered call early.
But first, let’s take a short look at the two scenarios in which you hold the covered call position until the expiration date.
Let the Covered Call Expire Worthless
If the stock price has stayed flat or slightly dropped as expiry approaches, you may simply let the calls expire worthless. The premium you obtained for writing the short call is yours to keep, and the obligation you had from selling the call (delivering the shares at the strike price if the option holder requires it) is removed from your trading account.
This implies, of course, that the stock has not fallen below your stop loss level, provided you set one.
When the expiry date approaches, the stock may trade just around the strike price. It is impossible to predict whether the short call option will end in-the-money or out-of-the-money in this scenario.
Remember that even if the call expires in-the-money by as little as $0.01, the shares of the underlying stock will be called away from you. When the stock is trading around the strike price, it may be more prudent to take action rather than hope the call would finish out-of-the-money and expire worthless.
Let the Stock to be Called Away
At expiration, if the short call option is in-the-money by as little as $0.01, the holder of the long call option will exercise their right to acquire the shares at the strike price, and your shares will be called away. In general, this is a positive scenario. Assuming you sold at-the-money or slightly out-of-the-money calls, you will be profitable. In fact, with covered calls, this is the greatest profit possible.
Both the stock and the call option will be deleted from your account when you are assigned. The net credit (equal to the number of shares multiplied by the strike price) will be credited into your brokerage trading account. Remember that you still get to keep the option premium you got when selling the covered call.
How to Close a Covered Call Early
When you establish a covered call position, you start with the ownership of 100 shares of the underlying asset and then you sell-to-open a call option against them at a certain strike price and expiration date. As a result, you have a short call option position.
The trade is formally referred to as Buy-Write when the underlying shares are purchased on the market and immediately followed by the sale of the covered call against them.
Closing a covered call before it expires is as easy as executing the reverse of what you did when you opened the trade. Previously, you sold to open the short call; now, you buy to close it, thus cancelling it out.
You retain ownership of the underlying 100 shares, which you may keep or dispose of as you see appropriate.
Let’s take a look at five scenarios in which you might want to consider closing a covered call before the expiration date.
#1 – Close a Covered Call Early for a Quick Profit
With options selling strategies, when the underlying stock makes a large move, you may find yourself in a situation where most, if not most, of the profit potential has already been realized. But in reality, they are unrealized until the position remains open.
Because of the nature of options and time decay, the closer an option comes to its expiry date, the faster its time decay. And, in the final 30 days, the rate of time decay accelerates exponentially.
If the stock rises sharply, the remaining time value on your short option contract will fall precipitously. On the contrary, when an option is in the money, theta, or the time decay component of its price, reaches its maximum level.
You sell to open an at-the-money covered call on a stock trading at $60 per share with 30 days to expiration, getting a $4 premium. A week later, the stock has risen to $80 per share.
Despite the fact that there are still three weeks till expiry, because the call is now deep in the money, the majority of the option’s value is intrinsic, as its theta component has collapsed. Assume there is just $1 of time value remaining until expiration.
In this example, you may receive 75% of the potential gains in just 25% of the time by closing the covered call early and selling the shares of the underlying stock at the same time. In terms of total dollars, your net proceeds in one week would be $2,300 (total of option premium kept plus capital gains on the shares value).
On the other hand, if you decide to keep the position until expiration (and assume the stock price remains at $80 until then), the total possible net profit on the overall position (shares plus short call option) would be $2,400 in four weeks.
Of course, it will depend on your own preference, but if, as in this example, you can lock in 75% of a trade’s potential profit in 25% of the time (compared to the original holding term till expiration date), closing covered calls early may be worth considering.
It’s true that by closing a covered call ahead of time for a net debit, you may leave some money on the table. However, one rule of thumb that many traders follow is to ask themselves if putting up what is left of the trade on a new position would be appealing enough. If not, there might be other, better ways to invest your money and time.
#2 – Close a Covered Call Early to Cut a Loss
Of course, equities may make large swings downhill as well, and unless you actually want to keep the stock for the long term, another legitimate motivation to close a covered call early is to reduce your losses on the position.
The premium you earn for selling a call will provide some downside protection, but if a stock falls precipitously, you will still be impacted (even if not as much as the investor who wrote no call on the same shares).
If you’re a covered call income trader (rather than a long-term investor looking to earn from the underlying stock’s price increase), your main objective is to profit from the covered call trade itself. Closing your position early when the trade makes a large move against you makes a lot of sense in this circumstance.
However, if you’re a long-term investor who sells calls on the side, holding tight and letting the call expire worthless may be your best alternative, as long as you have a strong belief in the underlying business’s quality and its long-term sustainability.
#3 – Close a Covered Call Early to Adjust the Position
Closing covered calls early and accepting a loss on your open positions just because the market has moved against you may not always be in your best interests. Sometimes adjusting a covered call is preferable to just closing it out. After all, options are named that way because that is what they provide.
Perhaps the trade goes against you just little, or perhaps the stock has a lot of implied volatility, allowing you to roll out for more net premium as you wait for the price to rebound. In any case, when you roll a position, you’re effectively closing out the previous one and replacing it with a new option position.
Of course, hoping and wishing will not bring a stock back. That is why, when putting up a covered call trade, or any trade or investment for that matter, stock selection is critical.
#4 – Close a Covered Call Early to Keep the Dividends
Dividends are another reason you might want to consider closing a covered call early, as option assignments can occur prior to expiry. This is most prevalent with dividend-paying stocks, but it may occur with any stock. Early assignment usually occurs on the day before the stock turns ex-dividend.
When an option is in-the-money (the current share price is greater than the strike price of the short call option) and dividends are due to be paid, the call buyer (the holder of the long call contract) may exercise the option early in order to possess the shares on ex-dividend day and thereby get the dividend instead of you.
In most circumstances, early assignment may be a good thing since it implies you made the greatest profit and did it ahead of schedule. Of course, not everyone who writes a call option on a stock intends to sell the shares. So, for a long-term investor, an early assignment may signify something else.
It’s rather simple to assess if you’ll receive an early assignment. Simply compare the dividend value to the option’s remaining time value (extrinsic value), which is calculated as the option current market price minus the intrinsic price. If the dividend value exceeds the time value, there’s a good probability you’ll be assigned before the ex-dividend date.
Do you want to ensure that you keep the dividend when you write a covered call? To do this, you must either but-to-close the in-the-money call before it expires or roll it out to a future expiry date when the time value is above the value of the current dividend being paid.
#5 – Close a Covered Call Early due to Earnings Volatility
Another incentive for closing a short call option ahead of the expiration date is to prevent the possible volatility of earnings announcements that normally occurs before the expiration date.
Holding a long stock position during an earnings announcement might expose you to a lot of downside risk unless you are a long-term investor in that specific company. Regardless of the analyst consensus data, there is always a lot of uncertainty and the possibility of negative surprises before an earnings report.
The company’s guidance for the following quarter and the rest of the current fiscal year is always subject to unpredictability. Often, the forecast, rather than the actual profits results, has a more direct influence on a stock’s price.
Typically, the uncertainty created by the forthcoming earnings event causes implied volatility to increase. As a result, the options premium level will be rather high heading into the report call. As a result, by closing early, you may be leaving quite a bit of money on the table.
Closing a covered call before the earnings announcement may result in low returns due to the option premium decay. If there is a big expected earnings report, the short call won’t lose much of its value until the uncertainty goes away after the event.
If you do well in the trade, it’s typically because the stock’s value increased, not because of time decay.
Please keep in mind that I am not an investment advisor or tax advisor, and do not offer any type of financial advice. These articles are only for educational purposes. The options market may not be appropriate for novice investors and may expose their brokerage trading account to unlimited risk and loss of the entire amount of their investment. Options are financial products that may not be appropriate for your financial situation, investment objectives, and risk tolerance. Past performance of options trading strategies does not guarantee future outcomes.