money: help me understand the "covered call"

Factual Questions
1

Not wanting to get myself into a financial instrument I don’t fully understand, I seek enlightenment from the SDMB.

I’ve got some MSFT. More than I really oughta have, from a diversification perspective. Obviously now is not a good time to sell it. But let’s say I’ve arbitrarily decided that if it miraculously hits $25 (it’s at $18 and change now, and it’s dropped that low and hit $25 once since the downturn), I absolutely want to unload it. I called up the money guy and asked him his opinion on setting up a sell order at $25, and he suggested a covered call instead. He spent about 20 minutes explaining, to the best of his ability, the details, and it sounds very nice, but I’m slightly uneasy because it sounds a little too good to be true. Specifically, I don’t understand the motivation of the guy on the other end of the transaction. Anyway, there’s some paperwork that needs to be done on the account before I can do it, so I’m doing the paperwork and mulling it over in the meantime.

My understanding (rounding everything for niceness):
The stock’s at $18 now. I sell an option to buy it at $24 until April. In exchange, I get $1 now. If the stock goes above $24, I end up pocketing $25, the same as I would with a limit order. If the stock goes far above $24, I end up kicking myself because I still only get $25, but that’s the same as it would have been with a limit order anyway. If the stock doesn’t go above $24, I end up pocketing the $1, plus I’ll be able to turn around and repeat the process (although as time goes on and the stock stays flat, the $1 premium people will pay will get smaller). It’s like free money! Woohoo!

Ok, so from the other perspective: who’s buying these options and why? What’s someone’s motivation to pay an extra dollar for the privilege of paying $24 for something that’s currently worth $18? I understand that having a locked in price is useful when things are volatile, but is there really enough of a chance that the stock will swing that wildly that someone will risk $1 on it? I feel like there must be an additional motivation that I’m missing, which makes me wary, since additional upside for the buyer often translates into additional downside for the seller.

The only downside I can think of (ok, money guy told me; I didn’t think of it myself) is that there’s a possibility that the stock jumps to, say, $26 for a day and the holder of the option doesn’t exercise it and it falls back to $18. I can’t unload the stock on my own during that spike, since I’m committed to selling it to the option holder if he exercises. So I could miss cashing in on the spike. However, I don’t see how this is an upside to the buyer; he missed out too. But I suppose this could actually be a fairly likely scenario if the holder of the option is trying to time the exact right peak to do an exercise+sell and misses it.

Comments, financial genuises? Are there more downsides to myself or upsides to the buyer that I haven’t thought of?

2

I think you understand it pretty well.

The market is very volatile. Someone would pay only 13 cents for the chance to buy at 24, 45 days from now, which doesn’t seem unreasonable. That’s the current premium. Go out a year from now, and apparently the market thinks that chance is worth two dollars. Who knows, if the economy does (much) better than expected, the buyer of that option could pocket 10 or 20 dollars.

Only comparing the two strategies, writing a covered call is better than a standing order to sell at 25.

3

What about the risk I mentioned of missing out on a spike? Is this a non-issue because it simply Doesn’t Happen in practice?

4

Another question: looking at the numbers for april options, there’s an obvious pattern: If you add the strike price and the current market value in a 3rd column I call “the bottom line”, the data points are clustered in the $21-23 neighborhood when you throw out the extremes. Is there insight to be found in this number? Does it hint at the market’s expectation of this stock?

5

According to the opinion of the market, yes. Option prices are a direct reflection of the probability distribution that the market assigns to the future price of the stock. If a potential buyer’s analysis suggests that a different probability distribution would be correct, he can profit with puts and calls. (Unless he’s wrong, of course.)

(Apologies if you already understand the next paragraph.) To less risk-averse investors, options are a convenient way to leverage up the potential profit (or loss, if in error) from these perceived mis-pricings. If an investor has only $100 to spare, he could by 5 shares of XYZCorp at $18. If the price makes it up to $29, he can sell these for a 61% ROI and a profit of $55. With that same $100, he could instead buy 100 call options at K=$24. If the price goes to $29, he could exercise his option and make $11 per share, or $1100 and a 1100% ROI.

Spikes don’t necessarily come into to (any more than they do with regular share calls and puts.) It’s about making the most out of a (perceived) profitable situation.

6

I also think you understand it pretty well. I have sold covered calls on many occasions and it’s a great way to earn a little extra on a stock you own while actually lowering the overall risk of that ownership. Yes, for that $1 you also incur the risk that you may miss out on a big return, but you don’t get something for nothing.

Furthermore, if the stock does go to $26 before the option expires, you can simply buy back the option and sell the stock. Obviously, the option will be worth more than the $1 you sold it for, but overall you come out ahead of where you are now.

7

It’s more a measure of the market’s uncertainty.

This total cannot be less than the current market value because then you could buy and immediately exercise the option, making a profit. On the other hand, it must go to zero at expiry, since you already know exactly how much it “will be” worth. In between now and expiry, this total will thus always be greater than the current market price, and how much greater depends on how broad the underlying probability distribution is.

8

Practically speaking, this is not a protection against the spike-for-a-single-day scenario, as there is some delay in the transactions, correct?

9

There can be many motivations. Maybe an investor genuinely believes that the price will be more than $25 in the future. Perhaps he is hedging a short position or is hedging against some other position he believes to be negatively correlated with the price performance of MSFT. And so on.

More generally, if you write a covered call, you can no longer sell the underlying stock without also buying back the call. You say you would “absolutely want to unload it” at $25, but how sure can you be? Perhaps business conditions may improve materially and you determine that the stock really is worth more than $25. Or you need to raise cash and decide that you’d be happy taking a smaller relative gain (say, at $21). Or things are really going down the tubes and you just want to get out as soon as possible before things get even worse. If you set a limit order at $25, you can always change your mind later as long as the price doesn’t hit the limit. By writing the call, you make it slightly more difficult to exit your position while the option is in effect.

10

Obviously, you can’t be 100% sure, but I worded it that way in order to ignore those issues. I’m specifically weighing setting a limit order and steadfastly sticking to it against doing a covered call. I suppose the relative ease with which one can change one’s mind should be factored into the pros and cons, but with this particular holding it’s not a big issue for me.

11

No, with most brokers you can do a simultaneous transaction.

12

Premiums from selling options are considered short term capital gains. I don’t know how long you’ve been holding the shares or how much of a impact this would have on your taxes. I’m just saying you should consider the tax implications too. If you are tax loss harvesting it might make filing a pain in the ass.

13

You might have to pay full retail commission if your call option is exercised at expiry because it is in the money. Check with your broker. (BTW, you will obviously be paying a commission when you sell your covered call.)

Also, the spread on option prices is usually greater than that of the underlying shares, and the volume of trades is much lower. You need to make sure you place the right limit order when selling the call, otherwise you could miss out some additional premium. Likewise if you want to close out your position.

And, why April calls and not January or July? How are you going to decide what’s the best expiry date? The closer to expiry date, the more likely your option will expire worthless (which is a good thing when you’re selling options) but the less premium you will collect. Also, which strike price is best? Find out why your “money guy” is recommending a particular contract.