July 26, 2017
4 minutes read
Behind every transaction, there is intention, a belief. Investors typically select options strategies with a clear objective in mind based on a predetermined outlook. One of the most popular strategies is the covered call strategy. We have discussed the covered call in depth in previous posts, but here is a quick summary.
The covered call involves owning or buying a stock and selling call options against that long stock position. The primary objective is to earn additional income to boost overall returns while the underlying remains fairly neutral to bullish. This is expected to occur within a specific time horizon since options, as opposed to stocks, have a limited lifespan.
Last Friday, July 21st, was the expiry date for July 2017 options. As expiration approaches, investors may feel a sense of urgency, especially if the underlying did not make the anticipated move. The optimal course of action is heavily dependent on whether or not the option has intrinsic value or not at expiration. The best case scenario, in the case of a covered call, is that the option is out-of-the-money on the expiry day. In this case, the option writer will keep the stock and the premium collected. However, if the option is in-the-money, a few options, pun intended, are available.
1. Do nothing
Should the underlying stock price exceed the strike price of the option at expiration, the option writer should expect to be assigned on his obligation to sell the stock. Assignation can be considered a success, especially if the investor’s outlook on the underlying has shifted. In the case of a covered call, the investor could potentially think that the stock is heading on a bearish trend and no longer wants to hold it. The premium will be his to keep, but he will no longer be a shareholder. He will instead be holding cash, which enables him to profit from new opportunities available in the market. It’s important to note that selling the underlying will have fiscal implications if the shares are held outside of a registered account.
2. Close the position
To avoid assignment in a rising market, the investor could potentially close the position by buying back the option contract that was originally sold. Note that since the stock price is now higher, the option price will have increased in value as well and will therefore be more expensive to buy back, which will result in a loss on the option.
3. Roll the option
If the investor wish to minimize the loss associated with buying back the option, they can “roll the option up and out” (higher strike price and further expiration month). Rolling the option would involve closing the original position, and selling another out-of-the-money call option with a further expiration month. There would still be a loss on the original option, but some of that loss will be reduced by the new premium collected.
The investor could also “roll out” the option with the same strike price. Typically, this course of action will be chosen if the investor maintain his original view on the stock and wish to reduce the risk in the position while increasing the odds of profitability by giving themselves more time.
This article focuses on standard expiry. However, the same could apply to weekly options.