Short
Call |
...or
Short Calls |
||||||||||||||||||||||||||||||||||||
 |
|
||||||||||||||||||||||||||||||||||||
Opinion:
Bearish |
|||||||||||||||||||||||||||||||||||||
| Description: | |||||||||||||||||||||||||||||||||||||
| The investor writing Call options should firmly believe that XYZ is not going up! XYZ doesn’t have to go down, but it most definitely cannot go up. This is because the strategy’s break-even point at expiration is a certain distance above the then current stock price. Thus, depending on the option’s strike price, writing Call options can be a viewed as a neutral to bearish strategy. | |||||||||||||||||||||||||||||||||||||
The investor who sells a Call option without owning either an equivalent number of shares in XYZ or another Call option has written an uncovered Call option. This strategy offers limited profit potential while exposing the investor to what could be extremely large losses! For this reason, writing uncovered Call options is unsuitable for all but the most experienced and deep-pocketed options professional! |
| Writing Calls: Why? |
Writing uncovered (“naked”) Call options is a
strategy with very high risk for a small potential return. Given this obvious
imbalance, why would a prudent investor wishing to preserve and build his
or her capital write Calls?
The key to the success of this strategy is to get to that point without having XYZ rally too far. If successful, profits will be small, given the risks. If XYZ “doesn’t go quietly,” one large up move could wipe out some, if not all, of the profits from may small wins! A word of advice: No matter how tempting it is, no matter how successful your friends have been, no matter how many months have passed with the at-the-money Call expiring worthless, no matter what, DON’T DO IT! For the average investor who’s regular day job does not involve the diligent monitoring of XYZ’s whereabouts, or for anyone wishing to get a restful nights sleep, this is sound advice! Insurance Salesman: All too often, option critics are quick to point out how speculative, risky and unnecessary options are. What they often fail to point out is that options are, for the most part, designed to be an instrument for the transference of risk. In the case of a Call writer, he or she is acting as an insurance salesman. For a small fee, the investor is willing to sell the Call buyer a policy, accept an unknown amount of risk, and hope that the word “takeover” is never heard! Is there a short-seller in the house? Writing Calls is not the same as a short sale of XYZ stock. If XYZ rallies above the strike price, the writer may still make a profit. To the downside, the short sale has much higher reward potential. If XYZ rallies above the strike and the Call is assigned, the investor’s new position will be short XYZ stock. For most option investors, this is neither a familiar nor a comfortable position. It is, however, altogether very possible! |
| Trade-offs: |
| The selection process is full of choices. With
four different expiration months and three, four, five or more different
strike prices for each month, the investor is confronted with a long list
of possible Call options to write.
Assuming that the previous advice was taken, most investor’s will be writing Calls as part of a more dynamic strategy. Thus, this review will focus on time decay along with strike price selection. |
| Purpose: Time Decay or Protection? | ||||||||||||
| When constructing a position which involves writing Calls,
the investor should focus on shat the Call sale is intended to accomplish.
An investor who has purchased ATM & OTM four to six month Calls might consider writing some near-term ATM or OTM Calls to offset the decay. An investor wanting to protect his or her stocks and/or option position against losses should XYZ decline, would write ITM Calls. ATM & OTM Calls: Time Decay. If the Call is being written so that its time decay will be used to offset the time decay of various long Calls in the position, the investor should focus on the first two expiration months (near-term options 1 & 2) for a candidate to write. An Example: Several weeks ago, with XYZ at $55, an investor purchased five XYZ Oct 55 Calls for 4 1/4. Today, XYZ is at $60 and the XYZ Oct 55 Calls are trading for 5 7/8. As a way of reducing the original capital investment, the option investor can write five XYZ Aug 60 Calls against the 55 Calls already owned. This creates a type of vertical spread known as a Diagonal Vertical Spread.
By writing the XYZ 60 Calls, the investor has changed the original position (long five Calls) in two very important ways. First, the investor has significantly reduced the amount of investment capital at risk. Second, the writing of the 60 Calls has capped the investor’s upside potential. While this is a very prudent investment management decision, it nevertheless involves a trade-off. Remember, the ATM near-term Calls are written because of their potential time decay ($). And, if they expire out-of-the- money, the investor’s “cap” has been removed! It’s a trade-off. While longer-term options offer more time premium, they may not decay quickly enough to suit the investor. On the other hand, near-term OTM Calls decay quickly but offer little in the way of protection ($’s) to the investor’s overall option strategy. ITM Calls: Writing For Protection Since an ITM Call does not have much time premium, it is not a good option to write for time decay. The higher prices found on ITM Calls are used mostly for downside protection for a position. An Example: Several months ago, with XYZ at $55, an investor purchased 500 shares of XYZ. Today, XYZ is at $60 and the investor is nervous about the possibility of XYZ declining over the next several months. While still bullish on XYZ, the investor decides to write five XYZ Calls against the stock position as a way of protecting either the unrealized gain ($5 per share) or some of the initial capital investment ($55 per share). Because the Calls with nearest expiration date (Near-term 1) have only some days left until expiration, the investor decides on the following XYZ Call options (Near-term 2) as potential candidates to write (i.e., sell) against the XYZ stock position.
Because of their larger premiums, the in-the-money (ITM) Calls offer the nervous stock investor more downside protection than the at-the-money (ATM) Calls. The final decision is based on how much protection the investor wants to obtain. This, of course, is a function of nervousness! If XYZ drops in price, an ITM or deep ITM Call will provide more protection than writing either an ATM or OTM Call. If XYZ rallies, the ITM Calls will likely produce a loss that will hopefully be offset by the gains in the investor’s long Call and/or long stock position. |
| Analysis of various expiration months: |
| Pros & Cons: Near-term options
(+) The decay of the time premium component of an option accelerates as the option approaches its expiration. (-) Near-term options do not contain very much time value. Pros & Cons: Longer-term options (+) The longer the option’s term, the higher its price. (More time value) (-) Rate of decay is slow and more time for rally to occur which could create losses (possibly large). Analysis of various strike prices: Pros & Cons: ATM & OTM options (+) Prices consist of all time value; decay of option accelerates as the option approaches its expiration. (-) Smaller premium may offer little protection if XYZ declines sharply. Pros & Cons: ITM options (+) Higher prices offer larger $ profits if XYZ declines. (-) Very little time decay. If XYZ rallies, ITM Call options produce losses similar to short stock position. Risk/Reward Characteristics: Break-even Point: At expiration, the break-even point (B.E.) is equal to the strike price of the Call option plus the Call option’s premium. Example: Oct 60 Call @ 4 3/4 Before expiration, the break-even point is lower. Profit: Profits are limited no matter how large the decline in XYZ. Loss: Losses are unlimited!! At expiration, for every point XYZ is above the strike price, the Call option increases an additional point in value. For each point above the break-even point, losses increase by a point. Time Decay: A Call option’s premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Call erodes (i.e., decays). At expiration, the Call’s value will equal its intrinsic value. Note: The rate of decay accelerates as the option’s expiration date nears. Changes in Implied Volatility: Changes in the option’s implied volatility has an effect on the “time value” portion of an option’s premium. Thus, a change in the option’s implied volatility has the same effect as changing (+/-) the number of days remaining until the option’s expiration. Early exercise of ITM Call options: The possibility exists that an ITM Call may be exercised prior to expiration. If occurs and the Call writer is assigned, the Call writer’s position will convert to that of short XYZ stock. Generally, the options with the highest risk of early exercise are the near-term ITM and deep ITM Call options right before XYZ’s ex-dividend date. All written Call options that are in-the-money should be monitored closely. Equivalent synthetic position: This strategy: Short 1 Oct 60 Call |