Short-Term Out-of-the-Money Covered Calls

I periodically employ a conservative ‘out of the money covered call’ option strategy when I think I can generate some option premium income and I have a strong probability of retaining the underlying security.

As a long-term investor I generally do not exit a position even if I think there is a strong probability a company’s share price could pullback. If I have invested in a company it is because I am prepared to hold my investment for the VERY long-term.

Having said this, I am not averse to writing short-term out-of-the-money covered calls if I think there is a strong probability the price of the underlying shares will remain below the strike price until the option expires. In doing so, my intent is merely to ‘skim’ additional income. This is exactly what I disclosed in my May 4th article.

Not every option trade will ‘pan out’ as planned but let’s have a look at the June 19 2020 $100 Chevron Corporation (CVX) covered call trade I disclosed in my May 4th article to see where things currently stand.

I wrote 10 contracts and collected $1.42/share; each contract represents 100 shares so I collected $1420 in option premium prior to nominal commission. Add the premium I collected to the strike price, make a slight allowance for the commission, and we get a breakeven price of ~$101.42. I could, therefore, close out my position just prior to expiry when CVX is trading at $101.20, for example, and I would generate a nominal profit.

As I compose this article I see this option contract is valued at $0.63/share. If I felt so inclined, I could have closed out my position today at a cost of ~$630 (10 contracts x 100 shares/contract x $0.63/share) before commission giving me a ~$790 profit. I continue to be of the opinion, however, that CVX’s share price will remain under the $100 strike price between now and the June 19th expiry so this position is still open.

NOTE: the time value of an option decays at an accelerating pace as we approach the option expiry date which works in my favor.

Covered Calls

I think the Big 5 Canadian banks in which I hold positions are going to report ugly Q1 2020 results the last week of this month and their respective share price will take a hit. In hindsight I should have written covered calls a few weeks ago since I was of this opinion back then!

I chose a July expiry because following the impending release of Q1 results there will be no earnings releases prior to expiry of the option contracts…I won’t need to worry about a positive earnings surprise prior to the July 17th option expiry date.

On May 22, 2020 I wrote the following July 19th covered calls through accounts for which I do not disclose details.

  • The Bank of Montreal (BMO) with a $72.00 strike price and received $0.80/share
  • The Bank of Nova Scotia (BNS) with a $56.00 strike price and received $0.50/share
  • The Canadian Imperial Bank of Commerce (CM) with a $88.00 strike price and received $1.06/share
  • The Royal Bank of Canada (RY) with a $90.00 strike price and received $1.08/share
  • The Toronto-Dominion Bank (TD) with a $60.00 strike price and received $0.79/share

In total I generated ~$4,000 in option premiums.

I did not write covered calls against all my Big 5 shares. For example, I wrote a dozen covered calls against a couple of banks because I held a sufficient number of shares in a particular account. I do, however, have exposure to these two banks in other accounts for which I did not write covered calls.

As disclosed in my May 4th article, if the share price of the underlying security exceeds the strike price come expiry, I would need to relinquish my shares. I certainly have no intention of parting with the underlying shares so I would repurchase the option contracts to close the positions. I could potentially suffer a loss if the amount required to close the positions exceeds the amount I collected when I wrote the contracts.

Final Thoughts

I think the share price of the Big 5 Canadian banks will remain under pressure in the short-term and the option contracts reflected above will expire worthless. If this ends up being the outcome I retain the option premiums collected AND the underlying shares.

Should the share price(s) of the underlying securities close above the strike price(s) come expiry I may decide to close out my positions and to incur a loss. In order to come up with the cash to close out the options I could use the option premiums I have just collected (and will keep in cash until the options expire) and/or I could generate option premium income by writing new out-of-the-money options further out on the calendar.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom!

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long BMO, BNS, CM, RY, and TD.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.