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Covered Calls

Oct 20, 2015

By: Sage Anderson

For those traders with directional bias, it can often make sense to trade an underlying stock as opposed to the options.

Options have a finite life cycle, which means they may expire before our expectations for the full value of these contracts comes to fruition. Stock, on the other hand, does not expire - unless of course the company goes out of business or it gets acquired.

On a recent episode of Tasty Bites, hosts Tom Sosnoff and Tony Battista review some situations in which a trader might take a long bias in a symbol. However, they also present the case for selling calls against the long stock to lower the cost basis of the purchase.

As Tom and Tony explain on the show, being long stock can be capital intensive when trading higher value names. However, if we are trading in a margin account, we are only required to put up 50% of the notional stock value. For example, if we buy 100 shares of XYZ for $15, we are only required to put down $750.

The specific situation that Tom and Tony highlight on Tasty Bites involves getting long a stock that has recently experienced a sell-off, but where a trader remains bullish on the company’s (or industry’s) prospects. Other criteria include filtering for names that have lower absolute prices (stocks or ETFs) and high implied volatility.

In these types of scenarios, the Tasty Bite team favors selling a call against the long stock (covered call), which can lower the cost basis in the stock. Such a trade also obviously caps the potential upside in the underlying during the life of the option (i.e. the stock gets called away before or at expiration and the long position disappears).

Writing covered calls has been a popular method of many portfolio managers over the years to boost returns during lean times. If the stock stays below the strike price of the short call, then the portfolio collects the income from the option sales. If the stock moves above the strike, the long stock is simply called away. Obviously the latter case means the trader misses out on the opportunity cost of the stock going higher.

With energy prices trading down significantly in 2015, Tom and Tony specifically point to the USO as a place they would consider this strategy.

USO was trading around $14.75 at the time this episode of Tasty Bites went live, with an implied volatility of 0.48 and an Implied Volatility Rank (IVR) of 68%.

Getting long the USO against a covered call allows for some flexibility in the timeframe of our expected revaluation in USO. Focusing on a liquid symbol also allows for good execution prices and sufficient liquidity.

The four scenarios below depict the lowered breakeven points our long stock trade achieves by layering on a short call at different hypothetical strike prices:

If a trader has an expectation that revaluation in an underlying could occur over an extended period, then the above structures could present a great opportunity to collect additional return during this waiting period. It's important to note that the above numbers are based on trading one contract for every 100 shares of stock (standard).

Periods of uncertainty in the markets that experience large selloffs are always followed by periods of volatility crush when markets stabilize. The approach detailed above is just another example of potential strategies a trader can deploy to take advantage of market conditions.

We encourage you to watch the entire episode of Tasty Bites focusing on covered calls when your schedule allows.

Also, please don't hesitate to follow-up with any questions or comments at support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

 


Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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