September 29, 2015
Options Education – Call Selling
The S&P 500 traded lower by 2.5% yesterday, though the real story was in the countless stocks that were down 4% or more. In early trade today, the market is bouncing back by 0.5%.
Many of us are holding personal stock positions that have taken a beating this year. If you are long too many stocks in the wrong sector, the pain has been extreme.
So how can you start to “dig out” of these holes? You can sell calls, using a “laddered” call selling strategy against these stock positions to lower our cost basis.
For this exercise, I am going to assume I bought 1,000 shares of Exxon Mobile (XOM) at 78. Since this fictional stock purchase, XOM is trading lower by 5.00.
When deciding which calls to sell against your stock purchase, ask yourself, “Am I willing to take a loss on some of my position, but at the same time recoup some of my loss on another piece of the position?” and “At what levels am I willing to sell my stock?”
This is how I might manage such a position:
The odds of XOM rallying above my original purchase price of 78 during October expiration are extremely small, so there is not much premium on any October calls. Because of this, I would not sell October calls.
November calls are a bit more intriguing. Because I have 1,000 shares, I’m able to sell a total of 10 calls against my stock position. In this exercise, I would sell five November 77.5 Calls for $0.75. I’d choose to sell five of my possible 10 calls in the November expiration cycle because I don’t believe the stock is likely to rally $5 in such a short period of time (my model prices in a 20% likelihood of XOM going above 77.5 by November expiration). While I would be less than thrilled that I may be selling part of my stock position at 78.25 (a profit of $0.25 per 100 shares), I would be thrilled that I made back $5 on my 1,000 shares as the stock rallied from 73 to 78. If XOM does not get back above 77.5 on November expiration, I will have collected $375 in premium.
With that sale of five November calls, I still have five more calls I could sell. I might look at December calls. I could sell three December 80 Calls for $0.60. If XOM closes above 80 on December expiration, I will be taken out of another 300 shares. However, those 300 shares would be closed at a profit because I had originally bought the stock at 78. If XOM closes below 80 on December expiration, I would collect another $180 in premium.
Next, I might sell my last two calls in the January expiration cycle–perhaps the January 82.5 Calls for $0.50. Again, in light of the recent selloff, I might be thrilled to exit the position for a profit of $5 on my remaining shares.
As you can see, there are plenty of opportunities of strikes/expiration cycles to choose from when selling calls. I tend to use a “laddered” approach that sells some shorter-term options, and then some longer-term options. This way, I can take advantage of short-term option decay when selling options expiring soon, and longer-term options for greater premiums at higher stock prices.
Once I have initiated these call sales, I must manage this position. Though in all reality, I only need to pay attention to these calls on the day that they expire. For example, if the original five November calls expire worthless, that next Monday after November expiration, I would then sell five more calls, and continue to roll these call sales until I’m taken out of the position.
I am sure very few of us are having much fun in this market. The hardest part of this year for most investors is that stocks that we once of thought of as “safe,” like XOM or Wal-Mart (WMT), have been crushed this year. However, with call sales, there are ways to cushion the pain and dig out of losing positions.