It's time for our question/trade idea of the week. Yesterday, Geert P. who has been following the Option Generator website for several months now, asked me the next question:
Good evening Hamish. I saw you've published several articles and webinars on the subject called in-the-money covered call writing for the purposes of investing defensively. Why aren't these options immediately exercised by the call buyer? So, essentially, why would we consider selling options with a strike price lower than current market value knowing it can be exercised faster than expected?
This is a very relevant question I get asked regularly. Let me highlight a trade idea with Progressive, PGR I've presented to the premium members.
Before we go over the details of the trade setups, let me address the reasons why in-the-money covered call writing perfectly applies to the current market environment.
Elevated Implied Volatility
In this volatile price action, option premiums are elevated, far above historical norms. That, in turn, leads to an edge i.e. shorting volatility in a covered way via covered calls or cash-secured puts. So, for the purposes of investing defensively, selling premium when it's rich is a very good strategy to pocket time value (our actual profit with dividend capture) and reduce our breakeven level. I, therefore, believe that we should focus on in-the-money covered call writing when volatility is elevated. Once volatility fears abate, you can turn to portfolio overwriting (i.e. monthly option selling) or more complex option strategies. For those looking to sell out-of-the-money covered calls, the best way to do it is via monthly option selling.
As for Progressive, the following implied volatility picture shows the discrepancy between current IV and its historical average of 18%. Volatility is now at 35%, so selling in-the-money covered calls makes total sense if we're concerned about the downside.
(Source: Market Chameleon)
The technical chart for Progressive indicates this stock sets up perfectly for buy and hold investors. However, there are times when Progressive gets caught in a rangebound/neutral market.The directional movement index is still pointing to bullish momentum, but the curve is flattening as is the MACD. In essence: although Progressive might serve as an attractive long-term buying opportunity, the technical indicators paint a rather mixed picture.
(Source: Pro Realtime)
In-The-Money Covered Calls With Progressive
Let's say you are interested in buying PGR, but believe that there isn't much upside potential from here. What can you do? Selling an in-the-money or at-the-money covered call with 9 months until expiration. The following screenshot is inserted below, utilizing the exclusive trade assistant I've created for the premium members.
As you can see from the graph I've just talked you about, the $77.5 call might be perfect for defensive investors. Let's evaluate the steps you should undertake:
Buying 100 shares at $82.87, resulting in a $8,287 cash investment
Selling the right but not the obligation to the call buyer, agreeing to sell your shares at $77.5 over the next 9 months (January 2021 expiration), at ANY TIME. Here's where the possibility of early exercise arises (see later)
Net cash back $1,270; when we sell an option, the cash is generated into our brokerage account instatenously. Including the regular dividend payments of 10 cents each quarter, we can generate an additional $40 per 100 shares.
Adjusted cost-basis including expected dividends: $69.77, or 15.81% lower than current market value
We generate a maximum profit as long as the share price does not depreciate by more than 6.48% by expiration Friday in January 2021
Our return is 9.33% if choose not to re-invest the cash premium we've just generated; otherwise the return would be 10.76%.
On an annualized basis, we have the possibility of generating a maximum return of 13.07% if shares do not depreciate by more than 6.48%. Our total cash back is thus $9,060 (strike price + entire premium + dividends).
Time value remaining in the option is $733 for the 100 shares or $7.33 per share. Why would the call buyer decide to give up the time value he's just paid to us?
If the option expires worthless in January 2021, we still own the shares at an adjusted cost-basis of $69.77. We can then start selling monthly options if the implied volatility is not attractive for covered call writing with longer-term options. Stated differently, we turn to traditional portfolio overwriting, since our breakeven point has already been lowered significantly.
When Does Early Exercise Occur?
If and when this situation takes place, it does not negatively impact our trade setup returns. Early exercise might occur in the following situations:
An option is in-the-money (which is the case)
There's an upcoming dividend payment (which is the case)
When the time value component of the option (the remaining time value, which can be calculated easily via our calculators) exceeds the dividend amount (which is not the case)
Why would the call buyer opt for early exercise? It is rare because option holders have control of the contract obligations up to contract expiration. The cash required to purchase shares can be left in interest-bearing accounts and capital-risk can be minimized by waiting until the last minutes of the contract. By exercising early, the call buyer gives up the entire time value component left in the option.
As for Progressive: when the time value component is lower than the upcoming dividend payment (let's say 10 cents, but there can be a yearly special dividends $2.25) and the option is in-the-money, there's a likelihood of early assignment. However, that does not have to be a bad situation. We have now freed up the capital that was locked up in the trade and can sell a new covered call (whether or not with the very same underlying).