The question here is: which is better, 11 or 1.5?
Many will be surprised by the answer: 1.5 is better. Yes, $ 150 is preferable given the time to expire $ 1,100. To illustrate this point, consider three LEAPS short options, all on Chevron (CVX) and based on the closing price on February 12th. The stock closed at $ 92.55 that day, comparing 92.50 views for different expiration dates. Assuming a covered call is the selected strategy, the promotional prices for calls for these three options are shown below:
- January 21, 2022 (342 days) 92.50 calling bid 9.90. Based on the current share price, the return is:
9.90 ÷ 92.55 = 10.70%
- June 17, 2022 (489 days) 92.50 call bid 11.10. Based on the current share price, the return is:
11.10 ÷ 92.55 = 11.99%
- January 20, 2023 (706 days) 92.50 call bid 11.25. Based on the current share price, the return is:
11.25 ≤ 92.55 = 12.16%
Those returns seem healthy enough. All are double digits. The problem is that the positions have to be kept open for such a long period (11 months, 16 months and 23.5 months). Not only does this tie up a trader’s capital, but it also prevents other opportunities that might arise during this holding period. The dollar value of these calls is healthy, but when the returns are annualized (adjusted as if the holding period were exactly one year) the true return is not as positive:
- January 21, 2022 (342 days) 10.70% ÷ 342 days * 365 days = 11.42%
- June 17, 2022 (489 days) 11.99% ÷ 489 days * 365 days = 8.95%
- January 20, 2023 (706 days) 12.16% ÷ 706 days * 365 days = 6.29%
Those returns are still not that bad, but they’re grim compared to short-term covered calls. For example, based on the CVX price at the end of February 12th, you should consider three options that expire within a month for both initial and annualized returns:
- February 26, 2021 (13 days) 1.54 ≤ 92.55 = 1.66%
Yearly: 1.66% ÷ 13 days * 365 days = 46.61%
- March 5, 2021 (20 days) 2.12 ≤ 92.55 = 2.29%
Yearly: 2.29% ÷ 20 days * 365 days = 41.79%
- March 12, 2021 (27 days) 2.44 ≤ 92.55 = 2.64%
Yearly: 2.64% ÷ 27 days * 365 days = 35.69%
This summary shows that the short term covered calls are more profitable on an annual basis than any LEAPS contract. If a trader wrote a two-week covered call 26 times in the coming year, as close to the money as possible, the total return would be far higher than if they wrote a one to two year call.
There are other advantages to drawing a stream of relatively small dollar amounts rather than using the LEAPS calls. Calls with longer term coverage react less to changes in intrinsic value than short-term contracts. More importantly, with the 2 week option, the time lag is quick and the chances of profitability are much higher. As the expiration approaches, the time decay accelerates, especially in the last week. For example, there is only one trading day between the Friday before the expiry and the Monday or the expiry week. but there is a three day time lag. On average, options lose a third of their time value between these three days.
Writing options every two weeks requires close monitoring to avoid exercising if the underlying price moves the option in the money. In this case the option can be closed or rolled. Rolling forward is not part of the ideal plan to get the double digit returns generated from high volume of calls covered. It might be preferable to accept an exercise, meaning that the premium is just profit, and the trader can then buy an additional 100 shares, either of the same underlying asset or a different one, and start the covered call writing process again.
An extension of the short-term covered call strategy is the use of the ratio write. This approach sells more calls than can be covered. For example, a trader owns 200 stocks and sells 3 at-the-money calls. It can be viewed as two covered calls and one uncovered call, or three partially covered calls. This is a moderate risk strategy. It generates more income than the one-on-one covered call, but it also carries risks.
To modify the risk, writing with a variable ratio is a sensible alternative. In this case, two strokes are used. For example, a trader owns 200 stocks at $ 92.55 per share. It opens a variable ratio write that combines two 92.50 calls and one 95 call. The OTM call can be closed when the underlying price begins to rise. If the two week approach is used, chances are good that it will result in low profit or break even. The less volatile the underlying asset, the lower the risk and the lower the premium a trader receives. This requires a balancing act between risk and return (like all option trades).
Knowing how the annualized rate of return changes the perception of covered calls and which ones are the most profitable. Many beginners immediately go to the longest-term LEAPS they can find, attracted by the much higher premium. When studying the math and comparing actual annualized returns, short-term options make more sense.
The total return is further increased if the underlying pays an exceptional dividend. For example, CVX earns a dividend of 5.16% per year. This is impressive in itself, but when you add it to the annualized return on covered calls, it’s irresistible. For example, the 13-day option in the previous example produced an annualized return of 46.61%. A dividend of 5.16% results in a net return of 51.77%. That is a difficult net return that cannot be achieved anywhere else.
Michael C. Thomsett is a widely published author with over 80 business and investment books, including the best-selling Get started with options coming in its 10th edition later this year. He also wrote the recently published The math of options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as Seeking Alpha, LinkedIn, Twitter and Facebook.