Schaeffer's Trading Floor Blog

When It Comes to Covered Calls, Should You Look Long-Term?

Answering a reader question on selling covered SU calls

by 8/23/2013 7:26 AM
Stocks quoted in this article:

Got this email from a friend:

My mother is retired and she owns a large number of SU shares. She wants to sell some or many of her shares, but at a price of $40 or above. SU is currently at $33.27.

Last year in October, I sold Jan 2014 calls with a strike price of $42. We've done well with that simple strategy.

The question I am faced with this year is as follows: Do I sell covered calls one year out (LEAPs), or do I attempt to sell options monthly?

It's an interesting question. Unfortunately, there's no correct answer. The idea is simply to accumulate as much money in premium as possible over the course of the year. If you sell LEAPS, you know that exact money right off the bat. You don't know if you actually will collect all that money, though; you may instead get called away and simply sell the stock. Or, if you so desire, you can buy the short calls back for (probably) a loss and roll them up. That's not so bad; the underlying stock position, which is the most important aspect, will have done very well.

If you sell near-term options and keep rolling them, you very well might ultimately generate more money in premium. You can adjust the strikes you sell -- say always sell 5% above the money or 10% above or whatever. You'll get called and/or forced to roll up at times, and other times you'll just take in the premium. I'd venture to guess you would actually generate more premium overall, but the risk is also much greater. You simply have less premium cushion at every given time, so are thus at risk of volatility spikes. And remember, that risk involves opportunity cost. If the stock blows above the strike you shorted, the position net-net makes money, but you've essentially sold the stock way earlier and cheaper than desired.

In a total vacuum, I might decide this the same way I would decide whether to go with a fixed- or an adjustable-rate mortgage. If interest rates are low, you want to go fixed and lock it in for lower. Same logic here -- if implied volatility is high, you want to lock that in and go longer.

In the real world, though, it's only most obvious in hindsight.

Here's a look at 180-day implied volatility (IV) in Suncor Energy Inc. (USA) (NYSE:SU) over the past year:

SU 180-day IV over the past year
Chart courtesy of iVolatility.com

Back in December, high-20's volatility going out in time looked very cheap. That would have suggested going short-term on the call writing. And that would have been a bad decision. Those IV "floors" are now ceilings. Locking in 28 IV out in time looks like it would have worked out quite well.

All things considered, I think I'd go with the LEAPS. It's one decision per year instead of 12, which if nothing else means 11 fewer chances for either market slippage or human slippage.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.


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