Another advisor goes even further, saying, “Selling covered call options and cash-secured puts is a smarter strategy than buying options because 90% of options expire worthlessly.”
Do Most Options Expire Worthless?
The truth is that neither of these beliefs is exactly accurate. The first person’s statements suggest that selling naked options—as an alternative to selling covered options—is a wise strategy. However, this too is fraught with risk. The second person’s statement is also flawed, but it contains a nugget of truth. More traders believe that it is “smarter” to sell, rather than buy, options. However, attention must be paid to limiting risk. Overall, writing covered calls is a sound strategy for most investors, though not as valuable for short-term traders.
Covered Call Writing and Expiring Options
Most option novices love writing covered calls when the option expires worthless. The truth is that this is often a satisfying result. Traders still own the stock, the option premium is in the bank, and it is time to write a new option and collect another premium. However, that mindset is a bit shortsighted. Sure, when traders buy a stock at $49 and write calls with a $50 strike price, and the options expire with the stock price at $49, the strategy has worked about as well as can be expected, and the traders are patting themselves on the back. There are two situations in which the traders who achieved this desired result (options expire worthless) probably made a serious mistake while waiting for the options to expire—a mistake that cost them cash. Let’s look at these seldom-discussed situations.
Situation #1: The Stock Price Has Plummeted
It may feel good to write an option for $200 and see it expire worthless. However, if that happens as the price of your underlying stock declines from your purchase price (for example, dropping from $49 to $41), that can’t feel very good. Sure, your losses are reduced because you sold the option, but depending on how much the stock tanked, the option premium may not take a sizable dent out of your loss. What are you going to do now? If you refuse to accept the reality of a $41 stock price and want to sell options with the same $50 strike, there are two potential problems. First, the $50 call might not even be available anymore. Second, if it is available, the premium will be quite low. This scenario presents a new question: Will you write a new kind of option? Are you willing to write options struck at $45, knowing that if you are lucky enough to see the stock price recover that much, the result would be a locked-in loss? The point is that the future becomes murky and knowing how to continue requires some investing experience. The proper technique would have been to manage position risk once the stock price moved below a previously chosen limit.
Situation #2: Implied Volatility Was High but Declined by Expiration
Option writers love it when implied volatility (IV) is well above its historical levels, because they can collect a higher-than-normal premium when writing their covered call options. Option premiums can be so attractive to sell that some traders ignore risk and trade an inappropriately high number of option contracts (creating issues related to position size). The option premium can vary as IV changes. Consider this scenario. You own a covered call position, having sold the $50 call on a stock currently priced at $49 when the stock market suddenly gets the jitters. That could be the result of a big political event, such as a presidential election or Brexit developments. Under customary market conditions, you are quite pleased to collect $150 to $170 when writing a one-month covered call. But in this hypothetical, high IV scenario—with only three days before your option expires—the option that you sold is priced at $1.00. That price is so absurdly high (typically, it is priced around $0.15), that you simply refuse to pay that much and decide to hold until the options expire.
What an Experienced Trader Would Do
The experienced trader doesn’t care about the price of that option in a vacuum. Instead, that more sophisticated trader also looks at the price of the option that expires one month later. In this enriched IV environment, they notice that the later-dated option is trading at $3.25. So what does our smart trader do? They enter a spread order to sell the call spread, collecting the difference, or $2.25 per share. The trade involves buying the near-term option (at an unattractive premium of $1.00) and selling the next month option (at an attractive premium of $3.25). The net cash credit for the trade is $225. That cash is the credit that you hope to keep when the new option expires worthless. Note that this is substantially higher than the normal income of $150 to $170 per month. Sure, you may have to pay a “terrible” price to cover the option sold earlier, but the only number that counts is the net cash collected when moving the position to the following month—that is your new potential profit for the coming month.
