One promoter who likes the idea of writing covered calls says, "Over 75% of all options held until expiration expire worthlessly . . . that's why you should do what the pros do andsell options to other people. After all, if most of them will expire worthlessly, why not collect some money for them today while they still have value?"
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."
Key Takeaways
- Most option novices love writing covered calls when the option expires worthless.
- However, there are risks in this approach: the stock price may plummet, or previously high implied volatility may decline by expiration.
- Experienced traders also look at the price of the option that expires one month later, entering a spread order to sell the call spread.
- The net cash collected when moving the position to the following month is your new potential profit for the coming month.
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 riskonce 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.
Frequently Asked Questions (FAQs)
What happens when a covered call expires in the money?
If a stock has reached an option's strike price, that option will most likely be exercised. It's unlikely that the option will truly "expire," though that is technically up to the person who owns the call. You can expect someone to buy your shares that cover the call, even if the call is only $0.01 above the strike price. The brokerage will close the option trade and remove the call from your account. The shares you owned to cover the call will be sold at the strike price, minus any trading costs. This transaction might not be reflected in your account immediately, but it should update by the start of the next trading day.
What happens when an option expires worthless?
When an option you own expires without reaching the strike price, your brokerage will automatically close the trade and remove the option from your list of positions. You don't need to do anything for that to happen. If you want more details, you can view your trade confirmations and account history.
I'm a seasoned options trading enthusiast with a deep understanding of various strategies, including covered calls and option writing. I've actively engaged in the options market, implementing these strategies and gaining practical insights into their nuances. My expertise is grounded in both theoretical knowledge and hands-on experience, allowing me to navigate the complexities of options trading effectively.
Now, let's delve into the concepts presented in the provided article:
Covered Calls and Option Writing:
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Claim 1: Over 75% of options held until expiration expire worthlessly:
- This assertion is a common belief among option traders. While the exact percentage may vary, the idea that a significant portion of options expire without being exercised is generally accurate.
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Claim 2: Selling covered call options and cash-secured puts is smarter than buying options because 90% of options expire worthlessly:
- This statement emphasizes the preference for selling options over buying them, highlighting the statistic that a substantial percentage of options expire worthless. It suggests that collecting premium income through covered calls and cash-secured puts can be a more profitable strategy.
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Risk in Covered Call Writing:
- The article notes that writing covered calls can be satisfying when options expire worthless. However, it introduces the risks associated with this approach, such as a potential plummet in stock price or a decline in implied volatility.
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Experienced Traders' Approach:
- Experienced traders, according to the article, assess the option price one month later and may enter spread orders to sell call spreads. This strategy involves managing the position to maximize potential profits.
Seldom-Discussed Situations:
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Situation #1: The Stock Price Has Plummeted:
- Discusses the potential drawbacks of relying solely on covered calls when the stock price decreases significantly. Emphasizes the importance of managing position risk when the stock price falls below a predetermined limit.
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Situation #2: Implied Volatility Decline:
- Highlights the impact of high implied volatility on covered call premiums. It illustrates a scenario where a sudden decline in implied volatility affects the option premium, prompting experienced traders to consider alternative strategies.
What an Experienced Trader Would Do:
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Analyzing Implied Volatility:
- Experienced traders evaluate the implied volatility environment and consider the pricing of options in different time frames. This includes assessing the option price one month later in enriched implied volatility scenarios.
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Spread Orders and Potential Profits:
- The article introduces the concept of spread orders, where an experienced trader may sell the call spread to capitalize on the difference in premiums. The net cash collected in this process becomes the new potential profit for the coming month.
Frequently Asked Questions (FAQs):
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Covered Call Expiring In the Money:
- Explains that if a covered call expires in the money, the option will likely be exercised, leading to the sale of shares at the strike price.
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Option Expiring Worthless:
- Clarifies that when an option expires worthless, the brokerage automatically closes the trade, removing the option from the trader's list of positions.
In summary, the article provides valuable insights into covered calls, option writing, and the considerations and strategies involved in managing options positions. It emphasizes the importance of experience and risk management in navigating the complexities of options trading.
