Papale on Covered Calls

Heard about a guy who, if Michigan State wins the NCAA Championship, wins $1,000,000.  Seems last December when the Spartans were a mere 5-3 and waffling after losing some seniors to graduation, the guy got 50-1 on a $20,000 bet.  Well fast forward and the casino who laid the odds is looking at the potential biggest payout they have ever made.  Question is does the guy hedge at this point or let the bet run?  My heart says let it run but my head (and risk management training) says hedge.  We shall see.

Covered calls and selling puts are a conservative, low management way to use options to potentially increase yield and lower risk.  From a performance perspective, there is no difference between selling a put and owning a stock and writing (selling) a call.  The returns might be a bit lower for the covered call strategy as the investment in the trade is larger due to the cost of the stock.  Most of the time we can put on either trade and pretty much forget about them.  Obviously if the stock collapses it may make sense to manage it and if the extrinsic value of the options get close to 0 we may roll the call or put, but unlike some other complex strategies like condors or butterflies, management is minimal.

That said however, these strategies are short vega, meaning that if implied volatility rises, our position will suffer.  For example we are short some April 31 calls in Intel.  That stock has been bouncing around in the last week or so and consequently IV has moved up around 10% to the mid 30’s.  Now we’re not making adjustments or worrying about any of that.  However, as in all short vega positions when vols go up, we are seeing a loss on our options positions from the short vega.  So in a selloff we may not see as much profit from the short calls as we might expect when vols rise.  So what do we do?  Nothing.  If the price of the stock is still ok than we just wait.  We know that eventually the inflated options must come back as all extrinsic value must go to 0.  Watch levels of the underlying but don’t worry about the options directly.  As they say, it will all work out in the end.

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