Covered Call Options Writing Strategy: An Update

by JDH on April 16, 2010

As I have discussed before, covered option call writing involves selling call options against stocks you own. A call option gives the owner the right to purchase a stock for a set price, before a set date. For example, if I own the April 60 call on AEM.TO – Agnico-Eagle Mines Ltd., I have the right to purchase Agnico-Eagle for $60 at any time prior to their expiry on the third Saturday of the month (ie. I would need to exercise them by Friday April 16, 2010).

Buying options is a high leverage, high risk game. I buy the option for, say $1, and if the underlying stock quickly increases by $2, the option could be worth $3. That’s leverage. Of course if the stock doesn’t increase in value, the option can be worthless, and I can lose everything. Big potential gains, but also potential 100% losses.

My strategy, instead of buying options, is to sell them. Since I own the stock, I can sell the underlying option without putting up any additional security or margin. Since I know that the option’s time value decreases as time goes on, I am selling something that I expect to decrease in value. If I can re-purchase it later for a lower price, I make money.

Here’s a quote from last week’s commentary, detailing my strategy:

As I reported on March 27 in my commentary on Gold Heading Higher, Market Heading Lower?:

If I’m correct and we have a bounce this week, I will follow my typical strategy and do some covered writing on these stocks to lock in my profits, and to get some downside protection.

Well, that’s exactly what I did. I bought more gold shares in the last week of March, including

Then, this week, I did covered writes on most of them. Brilliant, eh? The stocks went up when I said they would, and I covered to lock in my profits!

Actually, not so much.

Here’s a chart of one of my typical gold holdings:

This is the chart of AEM.TO – Agnico-Eagle Mines Ltd. On March 24 I increased my holdings, paying $56.45 per share (the blue arrow). Obviously I bought one day too early, but still, it closed Friday at 61.39, so that’s a great purchase point.

However, on April 6 (the red arrow), I then did a covered write, selling the then out of the money April 60 calls for 58 cents. Seemed like a good deal at the time, but of course the stock has increased every day since I locked in my profits. Oops. As of the close on Friday the bid/ask on the April 60 was $1.70 to $1.87, so I’m now down over $1 on that deal. Obviously I should not have sold the calls; I should have bought them.

Am I worried? Well, yes, a bit, since the options have one week to go to expiry (on April 17). If Agnico-Eagle drops $1.39 and closes below $60, the options expire worthless, and I’m fine. If they don’t, I’m forced to sell my shares at $60, which is a notional loss of $1.39 at today’s prices (less the 58 cent premium I took in).

For now, I’ll hold. We are obviously at an overhead resistance point (the green line), so a pullback from here would not be surprising, so this trade may still work out well. I’ll report back next week.

So, how did the strategy work?

Pretty well, actually.

This week most of the shares I covered fell, and the options expired worthless. Perfect. Here’s a summary:

  • AEM.TO – Agnico-Eagle Mines Ltd. – Sold April 60 calls for 58 cents; just prior to the close on Friday the stock was trading in the $60.30 to $60.40 range, so instead of having the stock called, I purchased the options to close at 45 cents; excluding commissions, I made a small profit (58 cents – 45 cents); the commissions are small, so even after commissions I made a small profit. The stock closed Friday at $60.29, and I still own the stock.
  • K.TO – Kinross Gold Corp. Sold April 18 calls for 29 cents; stock closed Friday at $17.94, so options expired worthless, and I still own the stock. I was six cents away from being exercised, so this is about as tight a trade as you want to make it.
  • G.TO – Goldcorp Inc. Sold April 40 calls for 25 cents; stock closed Friday at $39.44, so options expired worthless, and I still own the stock.
  • PBG.TO – Petrobank Energy and Resources Limited Sold April 58 calls for 65 cents; stock closed Friday at $52.45, so options expired worthless, and I still own the stock. (This is the only non-precious metals stock that I covered).
  • SLW.TO – Silver Wheaton Corp. Sold April 17 calls for 31 cents. On Friday at 1:40 pm the stock had traded down to $17.32, so it appeared that I would lose the stock if I didn’t close my position, so I closed my position by buying back the options I sold at 35 cents. So I lost 4 cents, plus commissions, on this trade. I still own the stock. If I had waited until the close, the stock closed at $17.50, so I made the correct decision to close out the position when I did.

So, out of the five stocks I covered around April 6, I made money on four of them, and lost a small amount on one of them. Overall, a successful strategy, in my view.

My profits on the strategy were relatively small, but the risk was virtually zero. I already owned the stock, and I sold the calls for above market value. Either way, I win. If the stock goes up and my shares get called, fine, I made a premium on the option sales, and I sold the stock at a higher price. If the stock doesn’t rise over the call price, I still own the stock, and I increased my returns by pocketing the premium. Since long term I want to own these stocks, it makes sense to “rent them out” for short periods of time to increase my returns.

That’s how I view it: I’m renting out my stocks to increase my returns.

Options are a depreciating asset, so selling some whose time premiums will erode, and then buying them back for a cheaper price, makes sense.

What will I do differently next month?

Ideally, you want to cover your shares after they have had a big run up. Stocks go up, and then they go down, so the time to cover is as they are peaking. My general rule of thumb is to cover after a stock has increased for three straight days. Four is even better. Since nothing goes up forever, this timing works.

Second, I like to cover when there are two to four weeks remaining to options expiration. The longer the time remaining to expiration, the higher the time premium. However, the longer to expiration, the more likely it is that the stock will go way up, and I lose the upside, so you have to balance more time versus less time.

So, for next month, I’ll wait for some up days to cover, and try to cover as far out of the money as is possible to still generate a decent premium.

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