The biggest downside of covered calls is their lack of downside protection on the underlying. A big, but not unusually big correction can wipe out many months worth of profits. One strategy for reducing this exposure is to buy puts, but when I have looked into this strategy in the past the puts were either so expensive they ate up all the profits, or they were so far out of the money that they didn’t offer much protection. I have found that the best way to really appreciate the strengths and weaknesses of a strategy is to have money at stake, so I started to look for a good situation to do some hedging on a covered call position.
Last Monday, August 9th I felt there was a higher than normal risk of a market pullback, but there was still the opportunity for making some good profits on the weekly options. Some downside protection seemed like a good idea, and the OTM 111 puts were attractively priced at 0.35. Late on the 9th I bought SPY at 113.01, sold-to-open 13-Aug 113 calls at 0.90, and bought 13-Aug 111 puts 0.35. Maximum profit on this trade was 0.55 per share, and worst case loss was 1.46. I had given up 39% of the profit to decrease the downside risk from essentially the entire value of the underlying to 1.46 per share. Since there was only 4 days left on this trade the remaining 0.48% profit potential was still attractive.
The market dropped off sharply on the 10th. In cases like this I will often buy back the calls. If I think the market is going to keep going down I’ll then sell ATM calls to harvest more premium, or if I think there will be a bounce back I’ll wait to re-sell the calls, hoping to sell them again at a higher price than I just bought them back at. In this case I bought back the 13-Aug 113 calls at .53, and later in the day resold them for .79 when the market did rebound a bit.
Wednesday the market really blew off. I bought back my 13-Aug 113 calls at 0.12 and quickly sold 13-Aug 111 calls at 0.61 which I bought back later in day for 0.39.
Thursday I sold 13-Aug 110 calls at 0.22 and bought them back later at 0.13
Friday I closed out the position early because I was not going to be able to monitor the position the rest of the day, selling the SPY at 108.61 (down 4.40 per share) and selling the 13-Aug 111 puts at 2.22 (up 1.87 per share)– I left about 0.2 on the table with the puts because I didn’t wait until near close to sell them.
In spite of all my call maneuvererings (which were all profitable) I was still down 1.18 per share, compared to the worst case loss of 1.46 from just holding the position. If I had not purchased the puts I would have been down 3.5 per share, almost triple the loss I ended up with.
Anyone that trades options knows that the pace quickens the last few days before expiration. The delta (the change in option price relative to the underlying) for the ATM option is still around .5, but instead of gradual changes for the deltas on the strikes in / out of the money, the curve starts resembling a step function, going from zero for out-of-the-money, to one for in-the-money at expiration. The time decay of the option premium (theta) also accelerates, with perhaps 50% of the decay in the last month happening in the last week of the option’s life.
Taken from http://www.option911.com/blog/option-education/how-option-time-premium-decays-over-the-weekend/, click to enlarge
All of this is of course modulated by any changes in the volatility of the underlying, and the market in general.
Some traders avoid options close to expiration because of these factors–and others flock to them. As a covered call writer I am really attracted to the accelerated time decay of short term options. I’m not taking any more risk than normal holding the underlying, and I am getting an accelerated decay in the price of the options I am short on. I will often wait until there is only two or three weeks are remaining on the options to create the position.
Now it can be expiration week, every week for the following Stocks / ETFs (taken from this CBOE posting):
Weeklys on Exchange Traded Funds and equities. As of July 5, 2010, these included the following::
I know that Fidelity and Schwab suppors trading onweekly options. Beware of the listed greeks on these options, the software may not be using the correct time until expiration.
The volume, at least on the SPY weeklies has been substantial (20K today on the 105′s expiring 9-July), so I think the options providers have a winner.
For more information see this options clearing house post.
Bought SPY at 114.69, sold-to-open 116 May calls at .58
