Is the Time Right for Covered Call Options?

Gunning Ju  |

Via fancycrave1

We're clearly in a bull market: the NADAQ Composite index has climbed 38.7% from the 2016 low, DJIA is up 33%, and S&P 500 is up 30%, while Russell 2000 small index has risen a massive 48%. All four indexes have not incurred a 10% correction for more than one year, a phenomenon that happened only in 2013 during this 8-year super bull market.

The present bull market is in complacency, as John Mauldin said in 2015, however, there are very few alarm bells (bears) going off. Market sentiment stays high as fear index VIX is at a multi-year low level. Long-term, mid-term and short-term technical trend indicators all manifest a bullish bias. But last Friday’s low volume seems to allude to something else. Normally, the volumes on options expiration days are extraordinarily higher than that of previous days.

Historically, during the first 100 days of a newly elected administration, S&P 500 slumps in February, according to Jeff Hirsch’s research. So far, the S&P 500 has soared 3.1% in February. How can we account for this market abnormality? One variant market view is that if S&P 500 follows this trend, the market will possibly exhibit some upside fatigue in the next week or so, fostering a mean-reversion.

The Dow Jones Index will encounter near-term resistance around 20850-20990. Accordingly, some investors may take advantage of market strength to bag some profits, thus causing some stock prices to stall or fall in narrow range. If this happens, writing covered a call option will not only let investors continue to hold stocks, but help them gather some options free-lunch.

Covered Call Writing

A covered call writing typically sells one contract call option for every 100 shares of underlying stock. Investors often use this strategy when they hold bullish longer-term views on stocks but want to collect some options premium either when markets stall or when stock prices drop or ascend slowly. Yet, writing a covered call does not makes much sense if stock prices fall sharply.

Delta Trail and Error Calculation

Option delta measures the expected change in an option’s value for one dollar change in the price of a stock. The key to writing call options is to find a low probability in which a stock price can hit strike price during a specific period of time. Since all options have time decay, call options writers can profit as long as a stock price cannot hit strike - the odds are 3-to-4.

We can use options delta to calculate rule of thumb strike price hit probability:

Options Strike Price Probability... A Simple Calculation

Options Strike Price Estimated Delta Probability to Hit Strike Price

  • At the Money........................................................................... 0.5 50%
  • At the Money to 1 Strike out of the Money...........................0.4 40%
  • 1 Strike out of the Money to 2 Strike out of the Money.......0.3 30%
  • 2 Strike out of the Money.........................................................0.2 20%
  • 3 Strike out of the Money.........................................................0.1 10%

Let’s say the current price of stock X is $100. The strike prices are $105, $110 and $115. In one month, or next options cycle, all thing being equal, the chance that the price of stock x will still be $100 or rise to $105 is 50% or 40%, respectively. So, writing an out of the money covered call will increase the odds of success. However, the premium for too out of the money options is also low. In this sense, investors need to measure this trade-off.

Two Types of Covered Call Options Candidates

In the current marketplace, investors can write two types of covered call options. The stocks with prices that are well above proper buy points, and those that will meet profit-taking selling pressure.

Netflix (NFLX) prices stalled after a solid earnings report in January, but rose to $142.22, nearly 10% from the latest proper buy points $129, close to the sell-side analyst consensus target price of $147, but well above the technical target price of $130.

Apple (AAPL) prices climbed 11% to $135.72 after the latest earnings report, 15% from proper buy point $117.67, approaching the sell-side analyst consensus target price of $139.82, but surpassing technical target price $134.

For those who are still bullish on the future of NFLX and AAPL, but worry about near-term price action, writing some covered calls on NFLA and AAPL will provide some insurance and additional income.

The After-N-day Positive Earnings Report Effects

In a bull market, solid earnings reports often send stock prices shooting up for several days in a row --- the N-day effect.

Case in point: NetEase (NTES) stock leaped up $36.88 (14%) to $298.73. Its weekly strike price $300 call options had premium $2.10 on Thursday, February 16, and became worthless on Friday, February 17. So investors who hold NTES shares can sell some out-of-the-money calls, exploiting the time value of calls when volatility fizzles out.

For this type of call option writing, it is critical to measure the upside limit of stock prices in near term. In general, stock prices can rise one to five days in a row, dependent on how stocks prices have discounted the earnings catalyst before earnings release.

Upcoming week the following stocks may offer investors some opportunity to write covered calls after earnings reports: Tesla (TSLA), Baidu, Inc. (BIDU), Stamps.com (STMP), Acacia Communications (ACIA).

……………………………..

This is just a personal opinion, and personal opinion is often wrong. Currently, the author has no position on any of the above mentioned stocks, and may or may not build any position on any stocks above in the future.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

Companies

Symbol Name Price Change % Volume
BIDU Baidu Inc. 117.05 -1.15 -0.97 3,832,088 Trade
TSLA Tesla Inc. 352.17 2.82 0.81 4,809,294 Trade
STMP Stamps.com Inc. 85.70 -0.07 -0.08 432,384 Trade
NTES NetEase Inc. 291.23 1.55 0.54 272,257 Trade
NFLX Netflix Inc. 295.03 5.41 1.87 6,335,606 Trade
ACIA Acacia Communications Inc. 67.08 0.59 0.89 322,344 Trade
AAPL Apple Inc. 265.76 3.12 1.19 25,064,676 Trade

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Symbol Last Price Change % Change
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HD

     
JPM

     
IBM

     
BA

     
WMT

     
DIS

     
GOOG

     
XOM

     
BRK.A

     
FB

     
JNJ

     
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NFLX

     
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PG

     

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