Calls for Sale: What's Best for You?

Successful call-writing means knowing how to pick the best option to suit your needs. Here's how.
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The options market is looking like the poor man's stock market. With U.S. equities getting pricier by the day, and tech stocks by the minute,

Brad "Doc Options" Zigler

decided to take some time out to play the numbers with call-writing. Have a big tech-stock portfolio that you don't want to sell, but want to add to your returns? You're probably not the only one, so here's some help on how to do it.

Most of all, enjoy the holiday, make some big resolutions for 2000 and keep the options questions coming to And, for resolution No. 1, include your full name with each question.

I've accumulated a sizable position in Intel (INTC) - Get Report over the years. I don't have other significant holdings. I'd like to use covered call-writing to generate income. What would be a better strategy to maximize premium receipts while avoiding exercise: writing covered calls each month, 10 to 15 points above the current stock price, or selling at-the-money covered calls six to nine months out, to take in larger premiums, figuring to buy back the calls on dips? -- Ramana Murthy Nemali


Good news or bad news? Which do you want to hear first?

The good news is you've built your wealth on a technology bellwether. Strangely enough, that's also the bad news. Having your portfolio concentrated in one issue ratchets up your volatility exposure (see the leverage discussion in

The Mechanics of Margin).

As a call-seller, you get paid for the obligation to sell the shares at the strike price if the buyer exercises the options.

If your Intel shares are called away, you face reinvestment risk. That is, can you find another stock that replicates or betters the gains Intel generates for the cost of the call strike price plus premium? If the stock tanks, there aren't any offsets in the portfolio either.

Whatever approach you select, your large stock position gives you the flexibility to write calls on only a portion of the portfolio, leaving the balance unfettered. Still, you need to know the relative merits of your alternatives.

Following any strategy blindly, of course, is folly. Especially with options. Market conditions change. Sometimes calls are screaming buys on relative cheapness; at other times, they're rich with inflated premium that begs to be sold. The true measure of option expense is the volatility assumption embedded in the premium (if you need to know more about volatility, see

A Beast By One Name or Another at the

Pacific Exchange's

Web site.

From one expiration to another in 1999, Intel averaged a 1/8-point monthly loss. Sounds like an ideal covered-writing opportunity, doesn't it? Returns, however, on an expiration-to-expiration basis, have been choppy.

As you can see, writing monthlong calls in the summer of '99 could have lifted you out of your portfolio position with gains averaging 18%. In other months, call premium receipts might not have been large enough to provide adequate downside protection for your stock holdings. Does that mean you'd have been better off writing the longer-term calls? Not necessarily. Hindsight is always 20/20. Any time an investment decision has to be made, you must consider current market conditions.

Here's an example of what market conditions offered around mid-December:

Intel stock was at 72 1/2. Out-of-the-money call: one-month call, 85 strike price, at 1 1/8 ($112.50). At-the-money call: seven-month call, 75 strike price, at 10 1/4 ($1,025).

The volatility embedded in Intel options is historically high -- in fact, higher than 95% of the past two years' readings. It's this kind of environment that equity options writers hope for. A return to volatility "normalcy" sets up potentially cheap option buybacks. But even so, which option to sell: the out-of-the-money one or the at-the-money one?

Since your stated objective for call-writing is income, let's first compare the returns which each strategy could produce, using the Intel data above. Since you didn't give me a cost basis for your Intel shares, I'll treat each position as a buy-write, using the stock's price as a cost base.

85 call

75 call

71 3/8

Net breakeven point

62 3/16


Annualized return if exercised



Annualized return if Intel unchanged



Percentage downside protection


The out-of-the-money call clearly offers scantier returns and less downside protection. Keep in mind, too, that the projected returns for the 85 call are hardly reliable. Still, we need a basis for comparison. Commissions haven't been taken into account in this comparison, either. Commissions would dramatically reduce the static return on the out-of-the-money call.

So, several points scored for the at-the-money call.

Now to muddy the water. Given Intel's current volatility, the 75 call has a 46% chance of going in the money during its lifetime. The 85-struck call, on the other hand, presents only a 13% risk. As a call-seller hoping to keep your stock, you might then favor the higher strike price (follow the links in the volatility article above to get to this kind of analysis).

Now it's crunch time: What avenue do you take? For you, the covered call's greatest utility is realized in a flat market, where you earn premium income and still retain your stock. You can use the information gleaned in the previous analysis to quantify the expected value for each alternative. Use the probability of each option staying out of the money, assuming volatility remains at current levels, together with the static returns.

Return if:

Relatively speaking, the at-the-money option offers better than six times the "value" of the out-of-the-money call.

There you have it, Ramana. Playing the numbers is not just some old-time neighborhood racket. It's how option traders give shape to risks and returns.

Brad Zigler is managing director for options marketing, research and education at the Pacific Exchange. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.