Evaluating A Covered Call

So, for whatever reason, I bought 100 shares of NVidia (NVDA) on February 19. I like their technology graphics cards and Christmas 2010 could prove to be a big win for them considering all the pent-up demand there is for new computers.

On the other hand, I think AMD is running away from CPU manufacturing and straight into NVidia’s graphics niche. Also, I know more people are buying notebook computers and most of those do not have dedicated graphics cards, which is where NVidia really shines.

Personally, I would never buy a computer that didn’t have a dedicated graphics card — it frees up the mainboard RAM for other more important jobs — but that’s just me …

Anyhow, I think NVidia could do really well by December, so I bought some. I am probably way ahead of myself on timing this trade, but I don’t want to be late for it either. I also know that most of the stocks I pick pretty much go nowhere — neither up nor down, just sideways. So, I need to work out a way to make some money from my purchase.

Ideally, I would have liked to just write a put on NVDA, set aside the money to purchase it at the strike, and move on. Today (February 19, 2010), for example, I would put $1370 aside and write an NVDA Sep10 15 Put for $1.30. The $130 I get for writing the put would be added to the $1370 already set aside, so that I’d have a total of $1500 set aside, hopefully swept into a money market account. With that money, I would be able to cover the cost of purchasing NVDA at the 15 strike if it goes below that price and the holder of the put I wrote exercises by the third Friday in September.

Writing a put this way is a pretty conservative trade because my downside is limited, and I can always buy back the put if the trade goes south on me. Which makes me wonder why your typical retirement account does not allow you to do this sort of trade — it’s very annoying.

When writing puts, you need to keep in mind that you’re locking up a certain amount of capital for the lifetime of the put. Here at the beginning of March 2010, we’re locking up $1,370 for just under 7 months. If the put expires out of the money, your $1,370 is freed up, and you’ve got $130. That is a 9.49% return in seven months, or 16.26% annualized. Not a bad return.

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This is in my Roth account, though, so my only option-oriented choice is writing a covered call. Before this trade, I had put in several different limit orders to buy stock like Altria (MO), Energy Recovery Inc. (ERII), and Gamestop (GME). The one that came through at the price I wanted was NVDA, so that’s what I have to work with. The first thing to remember when writing covered calls (or puts, for that matter…) is that early exercise only makes sense on dividend paying stock — the entity that owns the call you wrote may exercise early in order to capture the dividend., and the owner of a put may exercise early after the ex-dividend date because he has now captured the dividend and feels he can get a better return on the capital tied up in his stock elsewhere.  But NVDA doesn’t offer a dividend, so this isn’t an issue. It is highly unlikely that anyone would exercise this call before its expiration — if they do, I consider it a gift of the time premium factored into the price of the call I wrote. Rather than have to wait until September to redeploy my $1800 of capital plus $160 of option writing proceeds, I can take a step back and figure what to do with the money sooner.

Like I said, except in cases where a dividend is involved, early exercise of a written option doesn’t make sense and is therefore a highly unlikely event. Should it occur, it is beneficial to the option writer and detrimental to the exerciser.

With that out of the way, let’s look at the actual trade. I bought NVDA on February 19 at 16.55 — here were the calls I considered writing at the time:

Evaluating NVDA Sep10 Calls To Write - Feb 19-22

		NVDA purchased at:	$16.55
NVDA Sep 10 calls
Strike	Feb 22 Quote	NVDA Breakeven	Gains Cap	% Return From Write	% Gains Cap
17	2	$14.55	$2.45	12.08%	14.80%
18	1.6	$14.95	$3.05	9.67%	18.43%
19	1.2	$15.35	$3.65	7.25%	22.05%
20	0.95	$15.60	$4.40	5.74%	26.59%

Now I could go into some technical mumbo-jumbo and tell you how the trade I chose was the optimal trade, but that’s not how I chose my trade. You can already see by my choice of the September expiration when we’re in the end of February/beginning of March that I don’t like to tie up capital for much more than six months. This gives me a chance to watch two quarters and two earnings reports unfold. It also doesn’t lock me into the stock for very long if I don’t find it profitable. In the fast-paced options world though, six months until expiration can be a long time, and people are willing to pay for that. So long as the price I get for writing the call makes it worth the trade and so long as I still make a profit if the call is exercised, then I am willing to take their money. For me, options that expire sooner than six months from now tend not to be worth the effort to write because of their low price.

NVDA 18 Calls	Expiration Comparison
Expiry Date	Feb 22 Quote	NVDA Breakeven	Gains Cap	% Return from Write	% Annualized (approx.)
10-Mar	0.2	$16.35	$1.65	1.21%	14.50%
10-Apr	0.46	$16.09	$1.91	2.78%	16.68%
10-Jun	0.99	$15.56	$2.44	5.98%	17.95%
10-Sep	1.6	$14.95	$3.05	9.67%	16.57%

If you just take a look at the annualized returns on the write, it looks like I would have been better off writing the June call rather than the September. Honestly, this is not a factor I took into account when writing the call — I just thought that $1.66 was significantly better than $0.99. This is especially true if you take into account commissions. A $10 commission on writing a $0.99 call is considerably more expensive than on a $1.66 call, as a percentage of the transaction — 10 % on the first, compared to 6% on the second.

I admit this is in retrospect, but even considering the better return and shorter time horizon on writing the June 18 call rather than the September, I still think the September write is the better move. And this is simply because it has less friction. If we were dealing with 500 shares of NVDA and writing five corresponding contracts, the story would probably be different — the larger the trade the less friction there is.

At expiration, my covered call profile looks like this:

If my written call expires out of the money (i.e., if by the third Friday of September NVDA does not close above 18), then I can choose to either:

• Sell my shares of NVDA and move on to something else (this I would do if I thought my capital could be deployed better elsewhere);
• Hold on to my shares of NVDA but not write another call on it (in case I think the proceeds from writing the call do not compensate me enough for the risk of capping my gains again); or
• Write another covered call contract and pocket the proceeds.

If NVDA does close above 18 and my shares are called away, I will have maxed my gains at $3.05. I now have ($18.00 NVDA sale proceeds + $1.60 Covered Call Write in February) x 100 shares = $1960, whereas I started with only $1655, and that’s better than a sharp stick in your eye. Now I can decide to buy back NVDA, another stock, or just sit tight. If I do decide to buy NVDA or another stock, I would want to do buy writing a put. But that unfortunately, is not always possible.

By writing puts you have these advantages over other investors:

• You set your entry-point;
• You reduce your cost-basis for stock you eventually do buy;
• You profit if the put is not exercised, and that’s more profitable than creating a limit order on a stock that never gets filled.

By writing covered calls, you gain these advantages over other investors:

• You set your exit point — people seem to have some difficulty exiting a trade, if your covered call gets exercised this is done automatically for you;
• You reduce your cost-basis for stock already in your portfolio;
• You profit when your call is not exercised — if you, like me, tend to buy stock that just frustratingly goes sideways, writing calls is a great way to turn this weakness into a a strength. Think of it, if your stock never gets called away, you can just keeping writing calls and collecting the cash.

Whether writing covered calls or writing puts, you have to remember that you’re locking up capital for the life of the contract whether that capital is in the form of underlying stock for covered calls, or in the form of cash for written puts. In return, you can often get handsome returns.

Something to think about.

Note: It took a bit longer than I thought to write this, so the pricing is out of date — go figure, I write my first covered call, and it looks like it’s going to take off. Oh well.

Note also that writing covered calls isn’t going to be nearly as attractive other stocks. For example, I ran similar numbers for some AT&T stock that I’ve owned for ages, and the options I would have felt ok about writing just did not offer enough to be worth it. What’s the point in running the risk of writing a call for anything less than $75? Writing covered calls works best, I think, when the VIX is high and the underlying stock is somewhat volatile. In this case NVDA is volatile enough, even though the VIX wasn’t as high as I would have liked. The VIX was actually a bit too low, but the timing for the NVDA purchase was right.

Aw man, now I have to go look for an entertaining yet apropos photo for this article. Geez, you’d think two tables and two charts would be enough, but no …

When in doubt, grab the shot of whiskey.