By Chris Ebert
One of the more difficult aspects of trading is choosing when to sell a stock. It can be extremely frustrating to sell a stock for a 10% profit only to later watch it gain another 20%. While there are many technical tools available that may help a trader determine when a stock has reached a maximum price, an analysis of the stock’s covered call options can provide a quick and simple second opinion.
Altria Group (MO) stock has pulled back from its recent highs, however covered call option trades on this stock remain profitable, indicating that traders are likely to remain bullish, at least for now. While the decline in share price over the past few weeks warrants attention, covered calls opened 112 days prior to this week’s expiration date will continue to remain profitable unless Altria shares fall below the $32 level. Generally, when these types of option trades remain profitable, minor corrections in the share price are subsequently followed by the continuation of an uptrend.
To put it another way, “share renting”, as covered calls are sometimes described, currently remains profitable for Altria over a term of a few months (112 days). A good rental market is often indicative of good health in the stock, therefore Altria can be considered healthy unless the share price falls below $32 over the next week or so.
A covered call is one of the most basic option trades. A trader of most heavily traded stocks, and some that are not as heavily traded, can sell one call option for every 100 shares of stock owned. If the share price exceeds the strike price of the call option on the expiration date of that option, 100 shares are “called away”, in other words they are sold to the option buyer, at a price per share equal to the predetermined strike price. The trader selling the covered call receives a premium from the buyer.
Selling covered calls is sometimes referred to as “share renting”, especially when the strike price of the option is the same as the share price of the stock.
For example: A trader who owns 100 shares of a stock trading at $35 and who sells a call option at the $35 strike price is essentially agreeing to give the buyer total control of the stock until the expiration date of the option. The premium the seller receives from the buyer can be considered rent, much the same as a landlord receives rent from a tenant for total control of a piece of property. The buyer of the call option enjoys all of the profits of the stock (if there are any), while the seller gets to keep the premium as a form of rent, but without enjoying any profits on the stock itself.
When studying the profitability of renting, in order to determine the health of the underlying market, the time frame of the study becomes important. A landlord renting rooms by the week or month has a high probability of being affected by seasonal changes in demand, or short-term influences that are not indicative of the housing market itself. At the same time, a landlord using only 1 or 2-year leases may experience a considerable delay in realizing profits or losses that correlate with the housing market, as the tenant’s rental payments are generally locked-in for the duration of the lease.
In the stock market, a time frame of a few months is generally sufficient to study share renting in a way that minimizes short-term influences while also reacting quickly to changes in the market. The performance of covered calls opened 112 days prior to the expiration date of the options tends to be a good indicator of the health of the underlying stock. Those opened 7 days or 28 days prior to the expiration date are prone to short-term influences that do not necessarily reflect the health of the underlying stock. Those opened 1 or 2 years prior to the expiration date, often called LEAPS, are often too slow to react to changing conditions of the stock to be reliable indicators.
Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be available in actual trading.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options”.
Related Options Posts: