The reader asks…
"My understanding is that one can SELL a covered call on holdings in one's portfolio for every 100 shares of the underlying owned.
It is noted that when a person sells a covered call, the person receives the premium, and keeps that premium no matter what happens.
We're supposed to sell a call option that is 30 - 45 days to expiry, and just out of the money. (The strike price is just above the market price of the underlying stock).
Due to time decay, the option will significantly lose value as it approaches the expiration date.
What I find is, if the underlying stock is above the strike price at expiration, I have to lose money in order to buy back the option to close so I can keep my 100 shares. I find time decay does not reduce the option price for me to profit near expiration.
In some cases, if the underlying stock goes on a bull run, and the option expires deep in the money, it can be extremely costly to buy back the option to close and to keep the owned 100 shares. I find that I lose out on gains in the underlying stock.
If selling covered calls is a neutral to bullish strategy, why am I losing money buying back calls to close near expiration in order to keep my underlying shares owned?"
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Here is Costas' reply...
That's a great question! Thanks for writing in.
You don't lose money. What you lose is "opportunity cost" -- any gain above the strike price belongs to the option buyer, not the option seller.
Yes, it's true that when the stock goes significantly higher, you may have to buy back the call option at a higher price than what you sold it for.
And you may have lost money buying it back at that higher price
However, the stock has also gone higher in price.
And because you bought back the call option, you still retain the stock which has also gained in value.
So when you look at the gains of the stock and subtract what was lost in the call option you bought back, net-net, the position generates a profit.
When you factor both together -- the rise in the option price and stock price -- you'll find that you've actually made money when all is said and done.
(Although you would have made less money than had you not sold the call option against the stock in the first place.)
Let's say you sold the GLD August 170 call options for $3.00 with the ETF trading 165.
Now let's say GLD has traded sharply higher and is at $180 and options expiration is nearing.
You don't want to have the stock called away, so you buy the Call option back for $10.00 -- so you lost -$7 on the call option.
But you also own GLD, which has gone up $15 points from 165 to 180.
So on the stock, you made $15 but lost $7 on the Call option for a net profit of $8 on the position.
When you sell a covered call, your max gains are capped at the strike price plus whatever you took in for selling the call option.
In this example, the max gain was achieved -- $5 point rise in the stock price and $3 from call sale for a total of $8.
It might help you to always remember that covered call writing is an income generating strategy.
If you are expecting the stock to meaningfully rise in price, then selling an at-the-money or near-the-money call option may not be the appropriate strategy for the investing goal.
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That's it for this week's Friday Q&A edition of True Market Insider.
If you'd like one of our editors to address a trading question, or a question regarding any of our services, please send the question to info@truemarketinsiders.com.
Just keep in mind that we can't give you any specific investing advice.
To your successful financial future,
The True Market Insider Team
P.S. Costas has spent the past decade pulling back the curtain on options in his Profit Skimmer trading service—all while posting huge returns.
In fact, readers of Profit Skimmer recently saw gains of 57%... 71%... 94%... 123%.. and 130%... all in as little as 15 days.
To learn how Costas does it, just save a seat in his FREE online event, "10 Years of Profits." (And find out how you can get some of his hottest trades for yourself.)
You won't want to miss it.
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