The “Sweet Spot” For Covered Call Trades

Over the past few weeks, we’ve received some good questions from traders who want to know more about options. One of the best questions asked was about how to set up the best covered call strategy.

This makes sense. With market volatility beginning to pick up, and depressed interest rates not offering a lot of choices for income-seekers, there are a lot of traders who are reevaluating their choices for generating income in their investment accounts.

#-ad_banner-#With so many variables that go into setting up a portfolio of covered call positions, there are a number of ways to tweak the strategy. You can be more aggressive or conservative, balance short-term income against long-term stock gains, not to mention the different approaches to managing the level of activity and transaction costs.

One of the most hotly debated issues is whether it is better to sell long-term calls against your stock positions or to sell shorter-term contracts that expire within a few weeks. (By “long-term” we ‘re talking about using the three-month, six-month, or even 12-month call contracts.)

Let’s address this problem today, and talk about what we think is the “sweet spot” in regards to the duration for covered call trades.

Time Decay: Our Most Profitable Asset

As covered call traders, the majority of our income is derived from “time decay.” Let’s explain what that means.

Every standardized option contract that we use for our covered call trades has a predetermined expiration date. On this expiration date, the option contract will either be worth zero (if the underlying stock is below the strike price) or it will be worth the exact difference between the stock price and the option’s strike price.

When we sell our option contracts as part of our covered call trade, the contracts are always above the final expiration valuation. The contract is priced above the difference between the stock price and the strike price for in-the-money contracts. Or, it is above zero for out-of-the-money contracts. This is because options pricing includes a time premium — meaning buyers pay for the amount of time left on an option contract.

Since our strategy is selling call option contracts, we are the beneficiary of this time premium. We collect the premium upfront and then book a profit as the time expires. This is the underlying principle behind the term “time decay.”

As the Options Industry Council notes:

“Theta or time decay is not linear. The theoretical rate of decay will tend to increase as time to expiration decreases. Thus, the amount of decay indicated by Theta tends to be gradual at first and accelerates as expiration approaches.”

Now, let’s get back to the discussion of how much time we want left on our call option contracts when we sell them.

The thing that you should know is that the time decay line is fairly flat when there are many months left until the option contract expires. This is because, from a statistical perspective, there isn’t much difference between the probabilities for where the underlying stock will trade 27 months from now versus 36 months from now.

But when you consider option contracts that expire in a few months, you can see that the time decay drops off at an accelerated rate. This is because with only a few months or few weeks left before option expiration, there is less of a chance that the stock will make a very large advance. Since the potential profit for call buyers is lower (and dropping by the day), short-term calls become less attractive to buyers very quickly.

As a seller of call option contracts, we should love it when contracts we have sold decline in value. A rapid decline in option prices feeds profit directly into our covered call portfolio. So if we can set up more trades that expire relatively quickly, we receive a higher rate of return and get to book that return more times over the course of a year.

The (Feeble) Argument for Long-Term Covered Calls

When traders make a case for selling long-term options against their stock positions, they usually argue that the long-term approach gives them lower transaction costs because they make fewer trades every year.

There are two major issues with this line of reasoning:

1. Losing dollars to save pennies.

The brokerage business today is very competitive. You should be able to sell a contract for less than $2 in commissions, and sometimes a lot cheaper than that. (If you are paying $2 per contract or more, you are getting ripped off.) So the transaction costs that you might save from doing fewer trades per year represent minute savings. Meanwhile, you sacrifice a very large amount of potential income that you could be generating by selling shorter-term contracts. 

With more brokerages offering commission-free equity trades, expect to see this carry over into the options market. Bottom line, if you think you’re worried about paying commissions, you’re better off shopping around for a new broker than not trading at all.

2. Hidden slippage costs with long-term contracts.

Even though using long-term contracts may give you fewer total transactions, most long-term contracts are extremely illiquid. This means there aren’t a large number of buyers and sellers competing with each other. This makes it is hard to get a fair price when selling these options. Even if you are only selling one or two contracts, the bid-ask spread will be very wide. Again, this raises the likelihood that you will get ripped off for all but the most heavily traded stocks.

Action To Take

The only drawback for short-term (less than three-month) covered call contracts is that you have to continually scan the markets for new trading opportunities. It definitely takes more work to generate covered call income using shorter-term contracts. But the significantly higher returns make the extra work worthwhile. That’s why we think it’s the sweet spot for covered call trades.

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