Covered Call Writing - What affects the price of the options?

Question

A little while ago, I bought $800 worth of stocks and sold about $200 worth in call options against the stock. I think it was 200 shares and 2 contracts (so my options weren't naked).

That takes the price down quite a bit. It's sort of like getting 25% off in a way (once the options expired).

Now when I look at other stocks, I'm not finding this so easily. Usually it'll cover less than 10% of the cost.

So - what do I look for to find stocks that have options that will cover better (about a month ahead). I know that my first example was a stock that had a lot of news about to come out and a lot of people were buying puts against it. Is this why I could sell a call for so much?

What should I look for? It wasn't all time value because it was not even a month ahead.

Answer 1

All else being equal, you should look for more volatile (riskier) stocks.

Technically, it was all time value - the entire value of an "out of the money" option is time value. What's confusing is that time value is affected by numerous variables, only one of which is time.

The reason volatility is the one to look at is that all the rest are likely already intuitive to you, or are too minor an influence to worry about:

• Current risk-free interest rates and a stock's dividend payout during the life of the option affect the value of the call, but are usually minor infulences. (Higher interest rates makes call values higher, and higher dividend yield makes call values lower.)

• Longer time to expiration will increase the value of the call, but you're pretty likely already focused on that.

• The strike price's proximity to the current price affects the call's value - agreeing to sell a stock 5% above current levels will pay more than agreeing to sell it 10% above current levels - but again, this is likely obvious to you.

Volatility, or the percent by which the stock is likely to move up or down on a given day, is almost certainly the variable that's not already obvious.

Stocks that jump all over the place have higher volatility than those that move more predictably. The reason that options (calls and puts) cost more on higher volatility names is that options' payout is asymmetrical. In the case of calls, the option holder gets all the upside, but none of the downside, other than what they paid for the opotion. If one stock goes up or down $5 every day, and another goes up or down $20 every day and you could pay some fixed amount to get that stock's upside, but not have any exposure to its downside, other than that fixed amount, you'd pay more for the one that pays you $20 or $0 than you would for the one that pays you $5 or $0. That's why higher volatility (meaning larger daily moves) makes optimum prices higher.

Answer 2

Here are some things to consider if you want to employ a covered call strategy for consistent returns. The discussion also applies to written puts, as they're functionally equivalent.

Write covered calls only on fairly valued stock. If the stock is distinctly undervalued, just buy it. By writing the call, you cap the gains that it will achieve as the stock price gravitates to intrinsic value.

If the stock is overvalued, sell it, or just stay away. As the owner of a covered call position, you have full exposure to the downside of the stock. The premium received is normally way too small to protect against much of a drop in price.

The ideal candidate doesn't change in price much over the life of the position. Yes, this is low volatility, which brings low option premiums. As a seller you want high premiums. But this can't be judged in a vacuum. No matter how high the volatility in absolute terms, as a seller you're betting the market has overpriced volatility. If volatility is high, so premiums are fat, but the market is correct, then the very real risk of the stock dropping over the life of the position offsets the premium received.

One thing to look at is current implied volatility for the at-the-money (ATM), near-month call. Compare it to the two-year historical volatility (Morningstar has this conveniently displayed).

Moving away from pure volatility, consider writing calls about three months out, just slightly out of the money. The premium is all time value, and the time value decay accelerates in the final few months. (In theory, a series of one-month options would be higher time value, but there are frictional costs, and no guarantee that today's "good deal" will be repeatable twelve time per year.)

When comparing various strikes and expirations, compare time value per day.

To compare the same statistic across multiple companies, use time value per day as a percent of capital at risk. CaR is the price of the stock less the premium received. If you already own the stock, track it as if you just bought it for this strategy, so use the price on the day you wrote the call.

Along with time value per day, compare the simple annualized percent return, again, on capital at risk, measuring the return if a) the stock is called away, and b) the stock remains unchanged. I usually concentrate more on the second scenario, as we get the capital gain on the stock regardless, without the option strategy.

Ideally, you can also calculate the probability (based on implied volatility) of the stock achieving these price points by expiration. Measuring returns at many possible stock prices, you can develop an overall expected return.

I won't go into further detail, as it seems outside the scope here. Finally, I usually target a minimum of 25% annualized if the stock remains unchanged. You can, of course, adjust this up or down depending on your risk tolerance. I consider this to be conservative.

Answer 3

Matthew - what was the stock price and strike price of the option when you did this? I've never seen an at-the-money strike with only a month to run have a price 25% of the underlying stock. Jaydles covers the variables really well in his answer.

Answer 4

There are some excellent responses to this question at the time of this post. I have had the greatest success writing 1-month options. The 2 main reasons are as follows:

1. One month options generate the highest annualized returns.
2. It will facilitate avoiding quarterly earnings reports (a key rule in the BCI methodology). I will rarely own a stock for more than 2 months in a row for this reason.

With little time to expiration as stated in the question the implied volatility of the option is dictating the premium. Looking for the highest premiums is a mistake because you are taking a conservative strategy and re-creating it into a high-risk strategy. My sweet spot is a 2-4% monthly return for my initial profit and then mastering management techniques to protect that return and even enhancing it.