A Look At Covered Calls - GS On A Tear

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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I have another adjustment for GS placed on the Friday 27th. Essentially Goldman is on a tear and rocketed up the the next strike,trading at . This means we can pick up some more extrinsic at $111.81.

The 105 call we wrote at $4.45 I bought back for $7.85 once again taking a hit on intrinsic value of the option, even though we've made some on the extrinsic. Chalk up another situation where we would have been better off with just the stock (so far).

I've noshed up a spreadsheet to keep track:

No action on NOV or FCX

A Look At Covered Calls - The End Of The First Cycle

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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I've been very busy with my non-trading business and haven't had the time to post here as I would have liked, but I did record some adjustments in the intervening time.

But anyway, we've now come to the end of the first cycle of this project and good news, we've made a profit. I'll get to the bad news later.

FCX

FCX continued to surge higher and with the shares at around $42 I rolled the Jan39, taking a loss of $2.63, out to Jan42 and collecting $1.40 in premium. On Jan 11 we also got a $0.25 dividend which we must add to the results.

Last Thursday I closed out the January calls (as I wasn't going to be around Friday and do not want to be assigned) for $2.30, taking another loss on the short calls of 90c. Underlying was trading at $44.51.

Overall on our FCX covered call strategy we've made ~10.5%, an awesome result until we look a bit deeper.

• Had we have just held the shares, we would be 19.9% up! So the covered call strategy has cost us 9.4% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

GS

GS continued to surge higher and with the shares at around $100 I rolled the Jan95, taking a loss of $2.97, out to Jan100 and collecting $2.73 in premium. 

Last Thursday I closed out the January calls for $6.25, taking another loss on the short calls of $3.52. Underlying was trading at $106.55

Overall on our GS covered call strategy we've made ~8.9%, another awesome result until again we look a bit deeper.

• Had we have just held the shares, we would be 15.2% up! So the covered call strategy has cost us 6.3% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

NOV

Last Thursday I closed out the January calls for $5.50, taking a loss on the short calls of $3.14. Underlying was trading at $75.36

Overall on our NOV covered call strategy we've made ~8.2%, yet another awesome result until once again we look a bit deeper.

Same situation as the other two:

• Had we have just held the shares, we would be 16.9% up! So the covered call strategy has cost us 8.7% at this point in time.
• We have made money on extrinsic value of the options, but lost heavily on intrinsic by the calls being rolled when in the money.
• We haven't actually made any "income", all of our profit has been due to the strong rise in the stock.

These are the Feb calls I wrote for the next cycle:

• FCX Feb12 45 call for $1.52
• GS Feb12 105 call for $4.45
• NOV Feb12 75 call for $3.25

Still early days, but what we can glean from this first cycle is that covered calls cost you potential profits in strong uptrends and though still profitable, do not give you any cash income. You could just let the options expire in the money and be assigned in which case you would realize the extrinsic value of the options, but you would only realize cash from the stock to the value of the strike price.

Any way you look at it, the covered calls have cost us money so far.

We're Not All About Covered Calls

By the way, for those who have followed me over from my previous blog and any new readers that have found me, it might seem we're all about covered calls here. We're not.

There's lots more stuff to come.

A Look At Covered Calls - Jan 9 update

This is an update of my A Look at Covered Calls - The Naked Truth project. A hypothetical portfolio of systematic covered call writing (AKA synthetic naked put writing).

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FCX has been lingering around the $39 mark for a few days now. The Jan $37 calls have about 30c of extrinsic, whereas the ATM $39 Jan calls have around $1.00 of extrinsic.

The question is whether to pick up another 70c of extrinsic while losing the $2.00 of intrinsic hedge we have at the moment. I say stuff it, let's do it, we're all about premium collection here and damn the downside risk. :-P

I'm buying back the $37 calls at the offer of $2.52, a loss of 20c, and selling the Jan $39 for $1.17 with FCX trading at $39.21. So we're $1.89 to the good with the covered calls while just holding the stock would have us $2.09 in profit at this stage.

No action on NOV and GS.

Covered Call Are Naked Puts - The Proof

In my previous post I made the assertion that a covered call IS a naked put, synthetically. In this post I'll prove that with an example.

Firstly, it is important to know that every call option has a relationship with it's corresponding (same strike and expiry) put option as proven by and equation called the put/call parity equation. For your information, this equation goes like this: call price - corresponding put price = stock price - strike price + interest - dividend (if any).

It is not merely theoretical and we know this exists in the real traded market, because any anomalies in this relationship would be closed by arbitrageurs quicker than you can say 'Jack Robinson'. If for example call prices were too expensive compared to the corresponding put, arbitrageurs would sell the call, buy the put and buy the stock in equal proportions in a position called a conversion. This would guarantee a risk free profit. In reality, this is not achievable by a retail trader, so we can trust that option prices are in line with each other.

But I digress...

Let's suppose on Dec 15 2001 Tom the Trader wanted to collect some premium and had the view that GS would stay roughly where it is at around $92.50 or trickle up a bit until mid January 2012, so he sells 3 $90 Jan put contracts at $4.10, a face value of $27,000 (the amount Tom would have to cough up for the shares if assigned) and collecting $1230 in premium... a 'dangerous' naked put position.

If GS is above $90 as the January expiry date, Tom keeps his $1230 and pockets a tidy > 4% on the face value of the contracts (or > 12% on initial margin if you prefer looking at things that way {I don't}).

But what of the risk? What if Goldman has finally been caught out with one of its dirty deeds and the price collapses down to $70.00 by expiry? Well Tom could always cut his losses and exit before expiry, just like any trader can, but let's suppose Tom is a deer in the headlights and freezes?

Well Tom will most certainly be assigned the stock and will have paid face value for the stock, less the premium collected; a total of $25,770 for stock now worth $21,000. A loss of $4,770.

Ouch! Risky!

On the same day in Dec Tony the Trader thought it would be a great idea to do a covered call on GS, so buys 300 stock at $92.48 and sells 3 calls at $6.65. He pays $27,774 for the stock and collects $1,995 in call premium, bringing the cost base down to 25,779. Notice anything about similar about the put scenario yet?

If the stock closes anywhere at $90 or above at expiry, Tony will most certainly be assigned and will be paid $90 for the shares, collecting $27,000 ( a loss of $774) but will keep the $1995 call premium. This is an overall profit of $1,221.

But once again, what are the risks? Using our $70 at expiry scenario as we did with Tom's naked puts, Tony would be left holding stock now worth $21,000. He's lost $6,774 on the shares, but keeps the $1,995 call premium; an overall loss of  $4,779

Ouch! Risky also!

In each scenario the profit or loss of both traders is only $9 different to each other and this is accounted for by the interest accounted for in the option pricing model.

Pick any number at expiry and the profit or loss of these two scenarios will always be only $9 apart. Once interest for holding stock is accounted for, the result is the same. Because they are the same.

A covered call IS a (synthetic) naked put.

Covered Calls - The Naked Truth

Seeing as I have kicked off this blog by following a hypothetical portfolio of covered calls, I thought I'd have a bit of fun with a thought exercise. This is something every option professional knows, but many option noobies have a bit of trouble with.

We all know what a covered call is, long the stock and short calls in equal proportion. For example, if we Own or buy 100 of XYZ stock, we write 1 call contract.

Covered calls are variously promoted as a conservative option strategy, almost risk-less, easy monthly income and a host of other soothing adjectives and superlatives.

On the other hand, naked short puts are often castigated as being highly risky, having unlimited risk, dangerous, gambling and perhaps even having the potential to give you heart disease and herpes.

The overarching message is covered calls - good, naked puts - bad. Most covered call traders are quite comfortable with the strategy... initially at least. These same traders probably reach for their crucifix and don a string of garlic immediately naked puts are mentioned.

Unless you are au fait with option synthetics, you might be wondering why I'm talking about this.

It's because a covered call IS a naked put. Or more accurately, a covered call is a synthetic naked put. They have the same risks, same reward, same payoff diagram. If you are trading covered calls, you are ipso facto trading naked puts.

The only caveat to that is that the the strikes and expiry must be corresponding. So if you have a covered call with a $95 strike and March 2012 expiry, you in fact have a naked short march 2012 $95 put.


Need proof? I'll go through the maths in a later post.

A Look At Covered Calls Jan 4 2012 Update

So here we are on Jan 5 on our first covered call cycle, with a couple of weeks to expiry. I'm updating today because a couple of these positions now have very little extrinsic value left and could be rolled up to pick up a bit more extrinsic.

As to the P/L situation, I took the snapshot of the market a little earlier and this is how we stand:

GS

The stock is trading at 95.51, up 2.2% since inception last month

I rolled the option and got $5.95, a profit of $0.70 a further 0.75%, combined profit  of 2.95% so far. So for GS we are at this stage just a little bit further ahead with the covered call strategy.

I've gone and written the Jan12 95 call for $2.93

FCX


The stock is trading at 39.75, up 7.1% since inception last month

However our Jan12 37 call is $3.35 at the offer, an open loss of  $1.03 (not worth rolling this one) and 2.8%. For the strategy we are up $4.3%

Yes, around that magic 4% profit mark at the moment, but lo! We would be better off just holding the stock at the point.

NOV


The stock is trading at 70.49, up 9.4% since inception last month

I rolled the option and got $5.90, a loss of $2.45 which is 3.8%, combined profit  of 5.6% so far. So for NOV we are at this stage behind with the covered call strategy, even though on the face of it we are above the 4% per month thing

I've gone and written the Jan12 70 call for $2.36


I stress that at only a couple of weeks into this, these results are fairly meaningless and only worthy of reporting because of the adjustments. As we get a few months into this, it will get a lot more interesting.