Call options seem like pretty simple instruments until you're faced with expiration or big news coming down on the stocks you love. This week's Options Forum helps two investors grapple with some of the intricacies of call options.
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Short Call Conundrum
I would like to generate income from some of my long-term stock holdings by using out-of-the-money covered call writing. The problem is that I don't want these stocks ever called away from me because my cost basis is very low and I don't want to pay the substantial taxes that would be due. So, my question is: What are my risks of a stock being called (prior to expiration day) when the options are in-the-money? Is it just in the last few days? Does it relate to how deep in-the-money the option is? Are there other factors? Can the risk be quantified, or is it really almost negligible? I would like guidelines on when to buy back a covered call that has become in-the-money. M.J. Rossini
Yours is a relatively common concern.
Briefly, for the uninitiated, investors who are holding a stock they think has stalled a bit often will sell out-of-the-money calls to take in premium, hoping for the options to expire worth less. If the stock hits the strike price, though, they're faced with a dilemma: Do they wait for the calls to be exercised by the buyer and fork over their shares? Or do they buy the call back for a higher price but keep the stock and whatever potential it holds for more gain?
Typically, if someone is going to exercise an option, they'll wait until expiration. If they get itchy before that, they probably don't want a long-term commitment to the stock anyway and are more likely to just sell the option back into the market.
John Power, a former
Chicago Board of Options Exchange
investor-education maven and now the head of marketing at
, offered some advice for an investor who, like M.J., has decided to buy back the call options and hold his shares.
He says it's best to wait to buy the option back until all but the intrinsic value remains and all the time value and volatility elements of its price have been burned off.
Remember, options premiums have three primary elements: intrinsic value, or the amount by which the option is in-the-money; time premium, or the seller's cost associated with holding the option until expiration; and implied volatility, or the market's estimate of the stock's ability to make a drastic move in either direction.
The obvious reason it's best to wait is that if there's less time premium in the price, you're paying less to buy the option back. Like in every other facet of life, paying less is good. The danger is that while you're waiting for the time premium to deteriorate, the stock price can rise further and increase the intrinsic value of the option, making the option more expensive regardless of whether the time premium is at its lowest.
Power says that, generally, options begin to shed time premiums 30 days before they expire.
He says professional options traders use a handy rule of thumb to gauge when time has been removed from the call option's price. If the corresponding put option's price is the same or less than the call costs over the intrinsic value, it's time to buy it back.
Here's an example: Cisco is trading at 55, and the 50 call is trading for 5 1/2 six days before expiration. If the put costs 1/2 or less, you can buy back the call option safe in the knowledge that you've paid about as little as you can to protect your long stock position from being called away at expiration.
What happens when a company gets sold and you're holding its call options? For example, OneMain.com (ONEM) - Get Report, which was acquired last month by EarthLink (ELNK) , sold at $12.27. What happens to the call buyer with October 12 1/2 call options? Do the holders have to sell the contract without exercising it? Or will they get the stocks or call options of the new company? Dilip Patel
The thing you have to remember about this type of situation, options pros say, is that the options don't just disappear.
Alex Jacobson, one of the CBOE's options seminar instructors, says the options listing for OneMain.com likely will stay the same, but in most cases the delivery of that option upon its expiration will be adjusted to fit the terms of the deal.
We'll take a look at a simple case where a stock trading for 25 becomes part of a company that's trading for 50. The adjusted delivery of the old company's options contracts might change to give the call owner only half the number of shares but a dollar amount commensurate with that which the contract would have represented if the merger hadn't taken place.
It might be somewhat complicated to follow, but remember that each deal will have different terms. The Internet has been a big help because the exchanges will post changes in options on their Web sites. The
Trader's Tools section of the CBOE Web site is the one we're most familiar with, and it's fairly easy to navigate.