I wrote an article previously on why stable companies such as Apple generates low premium for options sellers due to low Implied Volatility (IV). Basically, to summarise, these big companies such as Microsoft, Apple, and Alphabet (Google) have very stable share prices and will not fluctuate much. Thus with lower volatility in their share prices, they do not command a high premium, which is proportional to the risk of price fluctuation.
You can read further here:
Why Apple Is Not A Good Stock For Options Traders (Sellers)?
However, I recently made a discovery on how we can get more returns out of these big and stable companies even though they may offer a very low premium on their options contract. I will illustrate with an example of an option contract that I have sold.
On 28 March 22, I sold a covered call contract on Apple, with a strike price of USD190 and an expiration date of 16 Sept 2022. It is a 172-day contract, which is roughly 6 months. I received a premium of USD705, which is 3.71%. It was an OTM call as USD190 was the strike price of my previous PUT contract when it was exercised. The premium could be higher if I were to choose a lower strike price that is close to the market share price at the time of purchase.
If I average out the total returns for this contract, the monthly return will be at 0.62% (3.71 / 6), which is not a lot in my opinion. I feel that a 1% return per month is decent while a 2% monthly return is desirable, especially as this year (2022) has not been as bullish as the last 2 years.
As of the 14 April 22 closing, Apple’s share price has closed at USD165.29. The premium of the covered call contract has dropped to USD420. If I had closed the contract at this premium price, I would have made a profit of USD285.
That will be a return of 1.5% of the invested capital, i.e. 285/ 19,000. The 1.5% return of capital is for 17 days (from 28 March to 14 April). If I average out to monthly returns, it will be 2.64% instead. So, getting 2.64% is definitely more than the 0.62% average monthly return that I get for the contract initially.
How Do I Explain This?
I explain this using delta. Delta refers to how much the premium of an option contract will move if the underlying share price moves. While the strike price is high, the delta of a 6-month contract of the same strike price is higher than if it was a one-month contract.
The delta of this contract is around 0.32, which means for every dollar movement (up or down), the premium will drop by $0.32. So, when the covered call contract was sold, the share price of Apple was USD173.53. On 14 April closing price of USD165.29, the drop is USD8.24.
Using a 0.32 delta, the drop in share price should be around USD2.63 (0.32 x 8.24), which translates to a total drop in the premium value of USD263. Give and take with the bid/sell pricing, together with the change in IV affecting premium, this calculated value is near to the actual drop of USD285.
How Do We Use This Strategy?
Sell a long-dated CALL option contract at the strike price that you are comfortable with selling, and the % returns that you are comfortable with. In the example used above, be happy with getting the 0.62% monthly return on Apple stock and selling Apple shares at a strike price of USD190.
What Is The Worst That Can Happen?
Scenario 1: The stock stays stagnant and eventually hit the strike price upon expiry.
Thus, you can only be getting 0.62% (or whatever returns you agree upon) for the next 6 months and you will sell away your shares at USD190 per share (or whatever strike price you are comfortable to sell).
Scenario 2: The stock shoots to the moon in the next 6 months and you miss out on potential gain.
This is the type of risk facing every CALL option seller. However, for a longer-dated CALL, the rise may be higher and the potential loss of extra profits may be higher due to more time for the share price to rise. In a market with high volatility, it may also mean more time for the share price to drop.
What Is the Best Outcome?
The stock continues to fall in the coming weeks, and the premium drops fast due to the higher delta value of the contract. In the example shared above, instead of getting 0.62% per month, I am getting 1.5% in 17 days due to Apple’s stock price dropping USD8.24 in share price. The contract can be closed in a short period for a higher profit margin, as compared to holding it for the long term until the contract expires.
In a year that is likely to see the market go down due to uncertainties over Federal Reserves’ rate hikes, quantitative tightening, high inflation, and an ongoing war, this method may work when the trend gets bearish. I think Scenario 2 (share price shooting to the moon) is not likely to happen this year. However, if it does, then the worst case would be selling our stock at the strike price we are comfortable with selling and the interest we are willing to accept.
Using this method, you get to keep a higher premium upfront (longer-dated options contract will bring a higher premium) and can choose to reinvest that money. It is also quite a safe bet as the price may not fluctuate too much due to the company’s stability and low volatility. If in an unforeseen circumstance whereby the stock crashes, it is a good thing for the option seller as well.
Lastly, selling a longer-dated CALL option means you have more time to do other things, you can have a longer time frame to monitor your share price and not be too concerned that the expiration date is near and you have to react accordingly. This might just be an advantage as compared to selling monthly CALL contracts.
Keen to learn about options trading but do not wish to pay for expensive courses, this newbie guide will help gain the knowledge and fundamentals to understand options better. And it’s totally free!
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