Options trading is an interesting and nuanced topic with tons of .. options. The easiest and arguably safest way to get started with options trading is by selling covered call options. So long as you are pricing your sold options appropriately there is zero downside and the only potential limitation is on upside.
A call option is a contract that gives the buyer the legal right but not the obligation to buy shares of the underlying stock or one futures contract at the strike price. They can do so at any time on or before expiration. The option is considered "covered" if the seller of the call option also owns the underlying security because they can deliver the instrument without buying it on the open market at potentially unfavorable pricing.
On Friday I had a bunch of options expire worthless which is good for me, but what makes this round of covered call options is that they were very out of the money during the week leading up to expiration. I thought the situation would make for a good demonstration of the pros and cons of selling covered call options.
For purposes of example, I will review the Shopify (SHOP) covered calls which I sold a couple weeks ago. I had picked up Shopify during a dip a few weeks back because I think the company has good long-term fundamentals in the e-commerce space and intend to hold them for a good while. In the tech selloff from a few weeks prior their price dipped significantly making them a good acquisition target and afterwards the price began to slowly increase.
My typical approach to selling call options is to:
- Sell for a couple weeks out: this ensures some regular income off the covered call options without waiting too long, but also means that there will likely be enough volatility in the options prices should I need to exit the position.
- Pick a strike price about 10% above current: except around earnings, I don't expect too many of my holding positions to rise more than 10% in a couple weeks, and if they do it is generally a good thing.
- Try to time to an upswing: if the market is sour, the call options will be cheaper than if the market is hot. Picking the right time to sell ensures that the price of the option is in your favor.
It is difficult to price anything when the White House changes their tune on a daily basis. In this case I sold covered call options not expecting much growth due to the trade war tensions started by the United States with Canada.
During the time between when I sold the options and their expirations the White House was quiet on tariffs for a week which allowed prices to drift up dramatically:
During the yeesh! spike the stock was up over 10% from my purchase price which made things quite interesting!
Let us pretend that I bought SHOP for $100/share, sold options for $110/share, and they raised to $115/share during this period, a week away from the call option expiration.
Option prices are (time value) + (intrinsic value) so my best option was
to wait until the expiration to act. That way the least time value possible
was attached to the price. Hypothetically speaking if SHOP was at $115/share at
the close on Friday, the option would have had $5 of intrinsic value which would mean I would have had the following choices:
- Buy back the option and take the loss on the difference between my sale price and the $5 of intrinsic value.
- Allow the option to be exercised by the buyer, which would pay me $10/share for the change between my cost and the option strike price. In this scenario the buyer gets a $115/share stock for $110/share. What a bargain!
This time around the stock sank like everything else in the tech sector on Wednesday/Thursday when the markets realized that consumer sentiment was still weakening and the White House was determined to jam tariffs into the economy one way or another.
As such, the price of SHOP went below the strike price of the options and therefore the options expired worthless and I got to keep the premium from selling the option.
Was this good trading?
Continuing the hypothetical pricing from above if I had zero covered call options outstanding, I could have sold my Shopify (SHOP) position at the high water mark of $115/share and made $15/share of profit. Because of the covered call contracts I was restricted from selling without first closing the call option by buying it back at the current market price.
In this situation I felt pretty confident that the stock price was going to come down either way on Friday. If I was behind or "out of the money" on my call options, I could buy them back for the cheapest possible price on Friday afternoon before expiration.
My stance is quite optimistic on Shopify (SHOP) so I believe that the stock is worth holding longer term. The +/- 10% fluctuation on the stock price during this call option contract duration is not something I am terribly concerned with. When I do exit Shopify, it will be for a much higher price than it hit during this past couple weeks.
Whether this was good trading or not is a bit subjective.
I didn't expect the big upswing in the options price when I sold the option. I could have made 5x more on the option premium had I waited another week to sell. Doing so would have required me to sell the option "in the money", in essence selling an option with a strike price of $105 when the stock was already at $110, a pessimistic/bearish strategy I have not ever used.
Buying back the options and offloading the stock at its peak would have probably netted the largest return, but also would have been quite bearish, since I would then be hoping that the stock price would drop (which it did) such that I could repurchase at a lower price than I had sold.
Selling covered calls is a good approach to options when you have no intention of selling during the period. The inflexibility that call options then place on you may not be worth it if you have intentions of closing out your position if the price is right.
The volatility pushed into the market by the White House makes it difficult to strategically do almost anything at the moment. Covered calls rely on some portion of the market being optimistic, which is very tricky to time right now.