Covered Call and Option Spread Trading for Income

Some of you may have noticed that some of the Covered Calls that the Guru has in the Conservative Account are ITM, but they have not been assigned (called) early. There are ways to minimize that possibility.

First, let’s discuss why an options trader buys a Call.

• It could be part of a option spread, in which case the trader is probably not interested in owning the stock.
• The trader may want to leverage an anticipated rise in the price of the stock and may also not be interested in owning the stock.
• The trader may be hedging and intends to buy the stock at a discount. In this case, the trader buys the call in anticipation of an event, particularly the date you need to own the stock in order to collect the dividend. In this case, if the extrinsic value of the option falls below the value of the dividend and it near the ExDiv date, the trader will exercise the Call option, buy the stock at the strike price, collect the dividend and make a few bucks on the deal. The trader then may sell the stock or hang on to it.

Those are just a few of the reasons a trader might buy a Call option. What I want to do is focus on the third bullet so we can create a strategy to avoid being called out on our Covered Calls.

Let’s use an example the Guru has in his Conservative Account right now. Eli Lilly (LLY) is a very good one since it’s ITM, pays a huge dividend and it’s a very good company. It currently has 1.1B shares outstanding and over 700,000,000 are held by institutions. Does this mean anything? Only that the institutions are not run by idiots and they are willing to do anything to grab more shares of this company at a ‘discount’. Look at the snapshot to the left (from www.dividendinvestor.com). Attractive, don’t you think? Forty-two years of consecutive dividend increases. Wow!

OK, back to business. You can see on the chart below that the Guru is short AUG 34 Calls and the price of the stock closed at 34.64 on Friday. The ExDiv Date is 8/11, so you need to own the stock on that date and hold it overnight in order to collect the dividend to be paid on 9/10.

So why hasn’t the Guru been called on this yet? Look at the option data below from the TOS platform.

The 34 option is currently 0.64 ITM, so the Intrinsic value is 0.64. Since the option is currently valued at 1.1955 (mid point of the bid/ask) the Extrinsic or Time Value of the option is 0.555 as shown in that column.

Notice also that as the strikes go deeper ITM the Extrinsic decreases. This is because delta increases as the strike price goes deeper ITM and the option price starts to move (almost) dollar-for-dollar with the price of the underlying.

So now the trader that’s holding the Call (or wants to buy some) is watching these number very closely. Once the Extrinsic falls below the Dividend, he may want to exercise his Call but will probably wait until close to the DivEx date. Why? Many times dividends get ‘priced in’ to the price of the underlying. If you look back on a chart of LLY you will see that around almost every DivEx date, the stock moves up by at least the value of the dividend. Coincidence? Maybe.

One other thing to consider – we don’t know when the trader bought that Call. Just ’cause we sold it last week, doesn’t mean it won’t get exercised because the buyer paid a huge premium. It’s not a one-for-one thing. You could get Called Out from a trader that buys a Call on 8/9 and exercises it on 8/10 even though you sold it on 7/14. It’s all a random thing. This quote is from www.theoptionsguide.com:

Once an option is sold, there exist a possibility for the option writer to be assigned to fulfill his or her obligation to buy or sell shares of the underlying stock on any business day. One can never tell when an assignment will take place. To ensure a fair distribution of assignments, the Options Clearing Corporation uses a random procedure to assign exercise notices to the accounts maintained with OCC by each Clearing Member. In turn, the assigned firm must use an exchange approved way to allocate those notices to individual accounts which have the short positions on those options.

Options are usually exercised when they get closer to expiration. The reason is that it does not make much sense to exercise an option when there is still time value left. Its more profitable to sell the option instead.

Over the years, only about 17% of options have been exercised. However, it does not mean that only 17% of your short options will be exercised. Many of those options that were not exercised were probably out-of-the-money to begin with and had expired worthless. In any case, at any point in time, the deeper into-the-money the short options, the more likely they will be exercised.

So what can the Guru do about this if the underlying stays ITM close to the ExDiv date? Pretty simple, really. The rule the Guru follows is: when the Extrinsic is near or at the value of the next dividend and the expiration date of the short Call is later than the date of the ExDiv, roll out or roll up/out to the next available month.

In the case of LLY, the ExDiv is prior to the AUG expiration. The Extrinsic is currently at 0.555 and the Dividend is 0.49. The option data will be monitored very closely was we near 8/11 and the appropriate action will be taken. Don’t worry, I will let you know what the Guru does.

Incidentally, the same rule for rolling applies as the expiration day draws nearer. I roll ITM Calls near expiration when the Extrinsic nears 0.10. Ultimately, though, it’s not the end of the world if you get called (see the If Called Return table on the right) – unless you are upside down and your cost basis is higher than you short Call strike. That’s an unfortunate situation and should be avoided at all costs.

A Quick Update on QCOM

I mentioned last week that the Guru wanted to dump it because of the low dividend yield. Well, he decided to wait another month when the opportunity came up to roll the JUL 37 to AUG for 1.03 in credit on Friday. How could anyone pass up $309? The next DivEx date is 8/25, so he will be in the market to unload it after that. The dividend of 0.19 was declared on 7/8 and that will bring the cost basis down to 35.12 and the Guru told me that now he wants to hold it until then. If the price is above 37 at AUG expiration, he may roll to SEP “something-or-other”.

It took me a long time to write this – I hope I was able to get my point across and I didn’t screw up.

◄ Jeff ►

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