Cover Calls Basics

1. I need to sell specific stocks to make a required portfolio adjustment, or
2. I want to milk out a little premium income on the stocks I am holding for the long-term

I do portfolio adjustments to realign my assets as personally require. Typically, I would just sell a stock, make whatever asset changes needed and then purchase a replacement that is trending up. However, as long as my need is not a fire-sell situation, I should have the patience to collect a little premium along the way.

For this scenario, selling a near ATM Cover Call that expires by week’s end seems reasonable.

For a perspective – if I sell 100 shares of a stock today and it goes up by week’s end then I’m a moron and wish I would have waited a week to sell. Likewise, if the stock price drops by week’s end then I’m a trader-savant. Regardless, I have to sell the stock and I do not know what the future holds. So it does not matter what day I sell, I’ll have the same visceral reactions one way or the other.

Selling a cover call option on a necessary stock sell to expire by week’s end is nothing more than scheduling a limit-sell order GTC. For a limit-sell order, I would set a price ceiling and set how long I want to wait until the price reaches that price (GTC). With a 5-day cover call option, I’m doing the same thing but collecting a little premium as I wait.

• One-week (1-5 days), deep OTM (> 90% probability OTM).
• One-month (24-29 days), deep OTM (> 90% probability OTM).

The cons with a 1-month strategy are:

• I will tie up my stock for the duration of the option.
• If my stock shoots up well beyond my strike price, then I lost that run-up for a puny premium.

• To expire ITM, it will have to have many consistently good days.

For a perspective – if I bought a new stock today and held it for a year and it had a 12% market value growth, I would be happy. 12% growth is not stellar on the aggressive-growth scale, but it is better than the average 1-year portfolio growth.

Therefore, if I bought that same new stock today and sold it after 30 days for a 12% return, should I not be ecstatic? If I don’t get premium greedy, any stock I have that makes 12%+ in 1 month should be a win.

1. Sell a 1-5 days near ATM (prob. OTM < 60%) cover call for the required stock.
   • If it expires worthless then resubmit next week, collect more premiums.
   • If it sky-rockets and then gets assigned then suck-it-up, I was selling it anyways plus I made a little extra with the premium collected.
   • In the last hour, if it appears it will close ITM but below the break-even price, then buy back the option contract as a profit then resell the same option next Monday. (Break-even prices will be discussed in a future post.)
2. Make sure the premium collected is greater than the assignment fees. I want to make money – not lose it.
3. DO NOT consider 5-day DOTM options for stocks I want to keep. They will be assigned more often than I think.

• Sell a 24-29 day DOTM (prob. OTM > 90%) cover call. Make sure the strike price is a percent growth that I would be happy with if it sold (suggesting 10%-ish).
  • If it expires worthless then I can resell the option again.
  • If it sky-rockets then it should have not gone too much beyond my strike price because I already calculated the skyrocket effect (+/- 10%) into the strike price I selected. I’ll call this sky-rocket factor “Head Room”.
  • If it gets assigned, immediately submit a limit-buy order for my original strike price (less all fees). When the market pulls back for profit-taking, then I can repurchase it at a break-even price.

Not all stocks make good Cover Call Options candidates. If I want to generate some income from Cover Calls I need to design my portfolio with good candidates. Some stocks are fairly low volume and do not have any Options. Many will have Monthlys and a smaller set will have both Monthlys and Weeklys.

Additionally, Options with higher volatility will have more premiums, and those with more premium means I can go further out of the money to find a worthwhile trade. So when I rebalance my portfolio, I need to keep an eye out for those stocks that also make good Cover Call candidates.

Finally, the market value of your stocks that you package for a Cover Call will also affect what is an acceptable risk.

Take AMD for an example;

• My assignment fee at Ameritrade is about $20. So ANY premium I collect must be more than $20 or I could lose money.
• Today, AMD sells for $29.92. So with a 10% Head Room, a starting strike price should be $33.
• Looking at a 29-day expiration, 1 contract at $33 strike price has a premium of $108 (Yeah!).
• However, the probability of OTM for this 29-day option at $33 strike is only 72% (Boo!) – which is well below my DOTM requirement of > 90%.
• Scanning down the options table a strike price with a prob.OTM > 90% is $37.5. This strike’s premium is $33 (obviously much less than the $108 sited above).

• Started 11 trades (6 Put Spreads and 5 Cover Calls).
• 11 trades have completed, 0 still cooking.
• Of the 11 completed trades, winners = 8 (+$417.00), losers = 3 (-$898.69)

• Started 15 trades (9 are cover calls and 6 are spreads).
• 7 trades have completed, 8 still cooking.
  Of the 7 completed trades, winners = 6 (+$328.30), loser = 1 (-$.40)

ETF:XLV $86.5p/85.5p – Expired 6/21 – Worthless – Net Premium Collected = $27.05

CSCO $56.5cc – Expired 6/21 – ITM – Net Premium Collected = $38.55

MSFT $138cc – Expired 6/21 – Worthless – Net Premium Collected = $26.05

ETF:DIA $251p/$246p – Expires 7/5 – Net Premium Collected = $99.05
Probability of OTM when traded was 79.7%. Now is 94.1%.

ETF:DIA $251p/$246p – Expires 7/12 – Net Premium Collected = $55.05
Probability of OTM when traded was 87.6%. Now is 90.4%.

ETF:QQQ $176p/$171p – Expires 7/12 – Net Premium Collected = $73.05
Probability of OTM when traded was 84.6%. Now is 83.8%.

Even though QQQ’s recent bounce up from the downward trend, it currently shows very little legs. However, the 9-Day SMA is still above the 50-Day, so I’m going with it.

This trade has the same short-strike as the QQQ trade I made last week. But because I saw the premium drop from what is essentially the identical spread, I took that as a good sign.

Note: There’s a fairly complex set of formula that is used to set the premium prices on options – including lots of Greeks, underlining fundamentals and the neurotic reactions by current traders. One outcome of all these machinations is that premiums tend to fall where the trading-herd is less likely to go. I’ll add to my decision matrix – falling premium prices is a good thing for crafting my Bull Put Spreads.

AMD $36cc – Open 6/26 – Expires 7/19 – Net Premium Collected = $48.55
Probability of OTM when traded was 93.5%. Head Room = 20.5%

 

I want to hang on to AMD for several reasons. One of which is that it has been a good cover call option candidate. The stock has been consistently trending upward. I can see it bounce around in the tend channel for the past 6+ months.

The strike price I selected is at the very top of the trend channel at expiration. If AMD continues doing what it has been doing then I should be golden…

CRM $150cc – Open 6/27 – Expires 6/28 – Net Premium Collected = $193.10
Probability of OTM when traded was 57.8%. HeadRoom <1%

For the past 3 months, CRM has been in a downward trend. The market analysts have downgraded the stock to a “Reduce/Sell”. With so many other stocks moving up, I’m going to dump this and buy something better.

I bought 200 shares at $143 back in Oct ’18. Today (6/27) the current price is $149.58, so I should make @$1,400 over the past 8 months. Plus, today I sold 2 contracts at a strike price of $150, expiring tomorrow, at a net premium of $193. Doing the math… this represents an 8.4% annualized return on this one investment.

ETF:SPY $280p/$270p – Open 6/28 – Expires 7/26 – Net Premium Collected = $76.05
Probability of OTM when traded was 80.2%.

Epilogue

Cheers…