Covered calls: How to handle this trade?

Question

I bought XNPT (Xenoport) a couple of weeks ago at 6.93 I turned right around and sold the Apr 16 call. $8.00 strike and collected 1.50 in premium.

Today I get a great surprise that XNPT has rocketed past 10.00. I fully expected my position to be automatically liquidated by whoever bought my call but in my account, sure enough, I still have 100 shares.

I use interactive brokers which is all the more surprising given their ruthless brutality at closing positions (I don't mean that in a bad way).

I did send them a request about this and I will update this thread with their advice. My questions then are this:

1. Am I the person responsible for liquidating this position?

2. If you were in my shoes what what would YOU have done to extend profitability on this trade, if anything?

UPDATE: IB says that liquidations aren't in real time. So I may have been called and my position liquidated already. I won't know until tomorrow morning.

Answer 1

I would expect that your position will be liquidated when the option expires, but not before. There's probably still some time value so it doesn't make sense for the buyer to exercise the option early and take your stock. Instead they could sell the option to someone else and collect the remaining time value.

Occasionally there's a weird situation for whatever reason, where an option has near-zero or negative time value, and then you might get an early exercise. But in general if there's time value someone would want to sell rather than exercise.

If the option hasn't expired, maybe the stock will even fall again and you'll keep it.

If the option just expired, maybe the exercise just hasn't been processed yet, it may take overnight or so.

Answer 2

You are NOT responsible for liquidating the position. You will either end up retaining your 100 sh. after expiration, or they will be called away automatically. You don't have to do anything. Extending profitability can mean different things, but a major consideration is whether or not you want to hold the stock or not. If so, you can buy back the in-the-money call and sell another one at-the-money, or further out. There are lots of options.

Answer 3

Your broker likely didn't close your position out because it is a covered position.

Why interfere with a trade that has no risk to it, from their perspective? There's no risk for the broker since your account holds the shares available for delivery (definition of covered), for if and when the options you wrote (sold) are exercised. And buyers of those options will eventually exercise the options (by expiration) if they remain in-the-money.

There's only a chance that an option buyer exercises prematurely, and usually they don't because there's often time value left in the option.

That the option buyer has an (ahem) "option" to exercise is a very key point. You wrote: "I fully expected my position to be automatically liquidated by whoever bought my call". That's a false assumption about the way options actually work. I suggest some study of the option exercise FAQs here:

• Options Industry Council - Options FAQ: Options Exercise. (The OIC is a somewhat definitive source for this kind of information and I like their learning materials.)

Perhaps if your position were uncovered – i.e. you wrote the call without owning the stock (don't try this at home, kids!) – and you also had insufficient margin to cover such a short position, then the broker might have justifiably liquidated your position.

Whereas, in a covered call situation, there's really no reason for them to want to interfere – and I would consider that interference, as opposed to helpful. The situation you've described is neither risky for them, nor out of the ordinary. It is (and should be) completely up to you to decide how to close out the position.

Anyway, your choices generally are:

• leave the options and shares be, while shouldering some downside risk in order to capture remaining time value premium by expiration, or
• buy back the options you wrote... and in doing so, pay back some of the time value you were hoping to capture (implied volatility may even have increased premiums) and then either:
  • re-write new options, or, if that is no longer attractive,
  • sell the underlying shares and look at other opportunities.