Out-of-The-Money vs In-The-Money Covered Call

There are 2 main type of covered call that you can do: out-of-money covered call (most popular) and in-the-money covered call, which mainly determined by your view or believe what the price of stock is going to be at the end of option period.
For example: a stock is now trading at $10 and option writer buy the option at that price to do covered call. Let say 1 month covered call for $10.5 strike price will give you 50 cents premium and 1 month covered call for $9.5 strike price will give you $1.0 permium per share (the additional $0.5 is the intrinsic value of the option – the actual premium(time value)/profit will be roughly the same – in this example 50c – in reality there could be some differences depending on the market). Then:

• If at the end of option period the stock go up to $11, both $9.5 and $10.5 option will be exercised. But there will be additional 50c profit of capital gain for $10.5 option writer (from buying at $10 and selling at $10.5) . See comparison table below:
  

  Price is $11 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	Yes	Yes
  Selling Price/ Excercise Price	$9.50	$10.50
  Capital Gain
  Sell:	$9.50	$10.50
  Buy:	$10.00	$10.00
  Net:	-$0.50	$0.50
  Total Premium	$1.00	$0.50
  Total Profit	$0.50	$1.00

• But if at the end of option period the stock go down to $9, both option will not be exercised, but $10.5 option writer will suffer (unrealized) loss of 50c ($1 capital loss: buy $10,  current value $9, minus 50c premium received) while the $9.5 option writer have not suffered any loss ($1 capital loss: buy $10, current value $9) minus $1 total premium. See comparison table below:
  

  Price is $9 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	No	No
  Present Value	$9.00	$9.00
  Capital Gain
  Present Value:	$9.00	$9.00
  Buy:	$10.00	$10.00
  Net:	-$1.00	-$1.00
  Total Premium	$1.00	$0.50
  Total Profit	$0.00	-$0.50

Hence, in the bearish climate -or- if you believe the stock will be heading down, in -the-money covered call would be better choice as it will give more downside protection.

Covered Call and Dividend

Now what happen if during your covered call period the company is distributing dividend? As you know, the price of the stock *usually* go down on ex-dividend date to self adjust the value of dividend that being taken from the market and only if you buy a stock before the ex-date you are entitled of the dividend, hence:

If the call option is “in-the-money”

Whether or not the option is exercised- 1 day before ex-date – is determined by dividend value and the rest of time value of the option.

• So, firstly check the time value of that option (check the premium for that particular option on the market and subtract it by intrinsic value)

Example 1

For example: let say we have:

• call option with $9.5 strike price
• Current price is $10
• the dividend will be 10cents
• the option price is now 80c (say, time value 30cents + 50c intrinsic value = 80 cents) with 2 weeks to go
• Hence, ex-date price is likely about $9.9 ($10 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital gain: 40c  ($9.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 80c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

Example 2

For example: the same as Example 1 above, except:

• the dividend will be 70cents
• the option price is now 60c (say, time value 10cents + 50c intrinsic value = 60 cents) with 1 weeks to go
• Ex-date price is likely about $9.3 ($10 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital profit: -20c  ($9.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

But as we can see, the difference between exercising and not exercising is now quite close with the diminishing of the time value of the option. If the time value is quite trivial, then there will be very little difference between exercising or not.

If this is the case, then additional motivation such as the option holder want the ownership of the stock (to vote on AGM for example) or other special offer exists, then it will be more profitable for option holder to just exercise the option.

If the option is still out of the money:

Example 3

For example: let say we have:

• call option with $9.5 strike price
• Current price is $9
• the dividend will be 10cents
• the option price is now 30c (all time value 30cents, no intrinsic value) with 2 weeks to go
• Hence, ex-date price is likely about $8.9 ($9 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: -60c  ($8.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 30c minus the buying price of the option.

Hence, it is very unlikely that the option will be exercised.

Example 4

For example: the same as Example 3 above, except:

• the dividend will be 70cents
• the call option price is now 10c (time value 10cents, no intrinsic value) with 1 weeks to go
• Ex-date price is likely about $8.3 ($9 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: $1.2  ($8.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is also very unlikely that the option will be exercised .

Note: (*) option need to be sold 1 day before ex date (on the decision day whether to exercise the option or just sell the option) before the price adjusted due to ex-dividend price behavior

Conclusion

If dividend is distributed in the middle of option period:

1. For out-of-the-money call option: the option will not be exercised
2. For in-the-money call option, if there is no special circumstances, option will not be exercised as well as it is more profitable for option holder to just sell the option to the market.
3. But if the motivation of the option holder is to own the stock , additionally the time value is not that significant and the profit from capital gain/dividend is not trivial (compare to the time value), then the in-the-money call option will be exercised before ex-date.

Ex-Dividend Date & Record Date

If a company declare that they will give the shareholder dividend, beside the amount of dividend, the company will also announce a “Record Date“. This is the date that you need to be recorded already on their book in order for the company to pay you the dividend. (Otherwise the dividend will be given to the previous shareholder).

When you are purchasing a stock or share, there will be a few days before that purchase is settled.  Meaning if you purchase a stock via your broker today, there will be a few day before your name registered/recorded on company’s book.  So, depending on your stock exchange “Ex-Dividend Date” or simply “ex-date” is a few days before the record date (in Australia:4 days before Record Date). This is actually the first day that you are not eligible for that dividend. Or in other word, you need to buy the stock/share before the Ex-Dividend Date in order to be given dividend on that time.

Because of this, Ex-Dividend Date is the most important date for investor and trader when it comes to dividend.

Typical Price Action on Ex-Dividend Date

The typical behavior of stock price on ex-dividend date is quite unique:

1. The price will usually open at starting price go down by the amount of the dividend. It’s not 100% always, an it is also not 100% exactly the same as dividend value, but approximately close. The logic is: when company is giving say 50c as dividend per share, it is actually taking out that 50c from company value as cash and giving it to the shareholder. So the overall company value on the market will be less.For example: company XYZ have 20 million share with price at $10. So total company value (market capitalization) is $200 million. If the company gives 15 cents dividend to shareholder, then the value of the company is literally down by 15c x 20 million share = $3 million down. Hence the price per share is equal to $9.85.
2. If the dividend is significantly high (compare to the stock-price or relative to the industry standard) it’s not unusual for the stock to rally a day before ex-date to compensate for item (1) above

Let see some real graph from real market price about this typical guidelines:

WITH STRONG MARKET SENTIMENT

• Home Depot (HD): Ex-Date: 1-Sep-2009 for 22c dividend. It closes $27,29 on 31-Aug-2009 to open 26c lower on ex-date. It closed even lower. Dow Jones Industrial Index (DJIA) closed 181 points lower, S&P500 closed 21 points lower.
  

  HD-Home Depot ex date 1 Sep 2009

  Price gap was formed on Ex-Date but the market sentiment of bearish day have more prominent effect after opening (Dow Jones ended down 181 points). This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• United Parcel Service (UPS): Ex-Date: 20-Aug-2009 for 45c dividend. Price were opened only 10c lower on ex-date, went to low  $52.24 before rally 67cents to end up $52.91 on that day. DJIA was up 71 points, S&P500 closed 11 points higher.
  

  UPS ex date:20-Aug-2009

  The price just went down 10 cents on the opening of ex-dividend date having push upward by market bullish sentiment. This follows marginally the typical price behavior on ex-date. The price is also follow the market sentiment as it went up from low on the day fuel by strong bullish market sentiment.

• Coca Cola (KO): Ex-date 9-Sep-2009 for dividend of 41 cents (3.08% yield). With DJIA up 51 points and S&P500 closed 8 points higher, KO open $50.13 (down 45 cents from $50.58) before rally strongly to $51.74 for $1.16 up
  

  Coca Cola-KO ex date 11-Sep-2009

  This follows the typical price behavour on ex-date, and rally even stronger than the overall market.

• Microsoft (MSFT): Ex-Date:18-Aug-2009 for 13c dividend. It open 4c higher. DJIA closed 83 points higher, S&P500 closed 9points higher.
  

  Microsoft (MSFT) ex-date 18-Aug-2009

  With strong upward pressure from the market, the ex-date price ended up higher. The price on ex-date also follows the market sentiment.

• Boeing Co (BA): Ex-Date: 5-Aug-2009 for 42c dividend. The ex-date open 53c lower from closing $44.16 before going back up. DJIA closed 34 points lower that date, S&P500 closed 3 points lower.
  

  Boeing-BA ex-date 5-Aug-2009

  The price was down larger than dividend value. This follows the typical price behavour on ex-date. The price on ex-date also follows the market sentiment.

WITHOUT/MINIMAL MARKET SENTIMENT

Let’s see more example with more neutral market:

• Glaxo Smith Kline (GSK): ex-date 29-Jul-2009 for 46c dividend. It closed $38.69 the day before and open down 21 cents at $38.48 before close 30 cents lower. Dow Jones Industrial Index was only 22 points down, S&P500 closed 3 points lower.
  

  Glaxo Kline Smith - GSK ex date 29-Jul-2009

  The price is gaped down on ex-date and close  down on that day. This follows marginally the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• McGraw Hill (MHP): Ex-date: 24-Aug-2009 for dividend of 22 cents (3.45% yield). Price close a day before at $29.67 but open 4cents lower $29.63 only to rally and close $1.04 higher. DJIA only went up 3 points higher, S&P500 closed 1 points lower.
  

  McGraw Hill-MHP ex date 24-Aug-2009

  The price opened at ex-date marginally lower but perform a strong rally despite neutral overall market sentiment.

• Qualcomm Inc (QCOM): Ex-Date:26-Aug-2009 for 17cents dividend. It closed on 25 Aug at $46.99 and open at exactly the same price the next day on ex-date. It rallied 54cents higher to close the day. DJIA only up 5 points, S&P500 closed 1 points higher.
  

  Qualcomm QCOM ex-date 26-Aug-2009

  The price did not go down on ex-date and even rally strongly even-though the Dow Jones index show some neutralit. The price on ex-date also follows the market sentiment.

• IBM: Ex-Date: 6 Aug-2009 for 55c dividend. It closes $118.47 a day earlier and finish the ex-date at $1.09 lower. DJIA closed 21 points lower, S&P500 closed 7 points lower.
  

  IBM ex date 6-Aug-2009

  With the strong market downward push, the price gap on ex-date was push further down. This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

• BHP Billiton (BHP): Ex-Date:2-Sep-2009 for 82c dividend (2.49% yield). It open $60.45 from $61.43 previous close (down 98 cents) before close $60.87 on ex-date. DJIA was down 25 points, S&P500 closed 1 points lower.
  

  BHP Billiton ex-date 2-Sep-2009

  The price gapped down on ex-date and follow the sentiment of the market down, but manage to finish higher than the open. This follows the typical price behavior on ex-date. The price on ex-date also follows the market sentiment.

Conclusion

From examples above all the stock (except MSFT and QCOM) were following the typical behavior describe above: the price drop on opening compare to the previous days before continue moving with market sentiment. But the overall market sentiment (Dow Jones index or broader S&P500 index) as a whole is still the dominant force to the exact movement of the price.

What is Diversification

Simply put, diversification is spreading your money to more than 1 type of investment. In term of stock / share trading, diversification could be investing in more than 1 stock, investing more than 1 type of industry, investing big, medium and small size company, etc.

Diversification Reduces Risk

Let see how and why diversification can reduce the risk. For example you have $10,000 to invest in stock market. And you want to invest in stock of company XYZ. What is the risk ? The risk is when the price of XYZ stock goes down. Now, let us simulate what happen if the stock go down by 50%:

1. Without diversification: you only buy XYZ stock, so all $10,000 is invested in this stock. If the stock goes down to 50% then the value of your stock is now $5000. (You have lost $5,000)
2. Diversification with 2 stocks: Let see if you do some diversification and instead of only investing in 1 stock, you invest in 2 different stocks: $5000 XYZ stock and $5000 other stock. So, let say the price of the other stock did not change, then if XYZ is 50% down, then your XYZ stock now worth only $2500, total value of your portfolio is $7500. (You have lost $2,500)Now, compare to (1), by using diversification, you have already reduce your risk by 50%. Now you only lost $2500 instead of $5000.
3. Diversification with 4 stocks:Let see further what happen if you do diversification with 4 stocks: $2500 XYZ stock, $2500 stock A, $2500 stock B, and $2500 stock C. With XYZ down 50% and other stays the same, you now incur a lost of only $1250.
4. Diversification with 100 stocks: If you do further diversification and invest in 100 stocks ($100 each), by the similar calculation, you will get that you only lost $50 for exactly the same events.

Clearly, by using diversification, we can see that risk have been distributed and the exposure of each item is reduced.

Diversification Limits Profit

Now, let see the flip scenario: what if the XYZ stock increase by 100% , yes, it doubles. Also we want to see the transaction cost – if each transaction cost us $10, what’s the correlation with diversification.

1. Without diversification:You only buy XYZ stock, hence the transaction cost is $10. The stocks has doubled in value, then your portfolio is now worth $20,000. A nice profit of $10,000. After transaction cost: $9,990 profit.
2. Diversification with 2 stocks: You buy 2 stocks, then your transaction cost is $20. The XYZ is now valued at $10,000 (asumming the other stock stays the same), then the portfolio is valued at $15,000. A profit of $5000. After transaction cost: $4,980 profit.
3. Diversification with 4 stocks: With 4 stocks, the transaction cost is $40. Total portfolio is $12,500 or a profit of $2,500. After transaction cost: $2,460 profit.
4. Diversification with 100 stocks: With 100 stocks, the transaction cost is now $1000. The total portfolio is now $9900+$200= $10,100. After transaction cost: $900 lost.

So, from this example we can see the transaction cost is going up in parallel with the number of diversification that we did. And the profit ? The more diversification we did, the less profit we got.

What To Do

The general wisdom is that we need to balance between minimizing risk and maximizing profit. It’s not really a good experience having your stock pick hit a jackpot and the stock doubles in value, but because of too much diversification you even cannot profit from it (see condition no (4) above).

So how many is enough ? It’s all depend on the size of your capital. The general rule that might be suitable for you is that you should not lost more than 5% of your total portfolio for any single transaction.  So, in this case, with $10,000 capital you should not lost more than $500 for any transaction. So if you want to tolerate 50% drop in value, that will be the $500. So, the value for each portfolio will be $1000. Or you will do diversification with 10 stocks.

You may want to vary your level of risk as well. For example 50% drop for blue chip companies maybe already very significant, but for small caps companies probably it’s still within the expected volatility. So, you need to work out your overal plan according to the type of the portfolio and your exit strategy.

If you have higher capital, you probably could make more diversification because:
(1) the proportion of transaction cost will be smaller
(2) you will be able to buy higher quantity of stock that will multiply the profit (and also loss) of the investment

Conclusion

You need to do diversification to reduce your exposure to certain risk associated with each item of your portfolio. But you need to do it so that you minimize your transaction cost and make sure any significant profit will give significant boost to the overall portfolio.

Happy Diversifying !

• As the term reveals, it started with buying some share in the share market. Say we buy 1000 shares of XYZ company for $10 each.
• At the same time, we will buy a put option at strike price $10 as protective put
• Then we hold those share until we reach the target.
• In the mean time, we can really ‘lock in’ our profit by ‘roll up’ the protective put (buying higher strike price put option as the price go up) or ‘roll down’ the protective put (selling the current put and buying lower strike price put).

To really understand how this work you need to understand how option works. Perhaps this article “How Option Produces Profit for Trader” may help. In a nutshell, when the price go down, the put option increase its value offseting the lost value of the stock.

The money

Using this “Protected BHP strategy”, investor make the money from 2 ways:

• Dividend income: only if the company distribute dividend
• Capital gain: when we sell the share and the share has gone up in value (the price has increased)

The disadvantage

There are 2 disadvantages with this strategy:

1. The protective put have a cost. It roughly should average around 1% per month. So, after 3 months, the stock need to go up above 3% before making profit. On the other word, put option for protection make the break even higher.
2. If the stock does not move at all, exactly at the same price when the option expired, you need to bear the cost of put option as a cost (your stock/capital is still protected but this cost will be incurred). Typically it will be around 3% – 5%. This is what I call “insurance cost”.
   As comparison, let’s talk about your car insurance. You pay insurance premium annually, if after one year nothing happen at your car, will the insurance company give back your premium ? OF course not… you actually will pay them another year of premium… This is exactly what happen here. The put option is your insurance, if it’s expired you need to pay another insurance.

But the advantage have much higher value than these tiny disadvantages: the stock is protected for any downturn so your capital will be 100% protected.

Better execution/alternative

Is there any better alternative? In fact , yes there is. Remember that you still need to bear the cost of put option whether the market will go up or down? How about like this: if the market go up: you make a profit less put option cost. If the market go down: your capital is protected (no loss) but also you got back the cost of your put option. I think this is almost what so called ‘perfect investment’ – it will require a little bit more calculation but it’s still simple.

To find out more: goto “Near Perfect Share Trading: NPST”

To see what happen if there is no protection on your share trading go to “BHP: the classic share trading strategy“.

A trader can make profit basically by buying a company share at certain price, say $10, and sell it at higher price. The problem is that no body can actually have the power to direct the price movement (go up or go down) except the market mechanism itself. Read “How The Prices Moves in Market” article to see more detail. So, in other word, any trader do not have any direct control that let he/she knows whether the price will go up or go down.

If it’s the case, then what makes some traders are really profitable and on the other hand some are really loser?

In general, there are 3 dominant factors that determine whether a stock price of a company go up or go down:

1. The Fundamental Factors of that company
2. The market sentiment
3. The Technical Analysis factors

The Fundamental Factors

On of the main factor that determine the condition of a company is how profitable the company is. If the net profit is growing quarter after quarter, then the value of the company will go up as well. SInce the number of share is constant, then the price will go up.

There are also so many other factors that can shape up the fundamental condition of a company such as: whether the debt is under control, price per earning ratio, company growth, market share, product diversification, etc, etc…..

Fundamental factors is more important in longer time frame investment (multiple years)

The Market Sentiment

This factor is quite hard to determine. We cannot predict what is exactly the market really want at certain time. You can see this factor as the “mood” of the market as a whole. If Dow Jones Index down 400 points overnight, then Australian stock market will almost certain to be down as well because the sentiment is negative.  If there is terrorist attack, the mood become negative. This factor is the one explain why just after GE (General Electric) announced that their profit has increased, the whole market bounce back from going down to rally up.

What we can be certain is only one: if there are too many seller then the price of the stock will go down, and if there is too many buyer, the price will go up…

Market sentiment is more prominent for short term price movement.

The Technical Analysis Factors

This third factor is becoming more and more prominent as almost all traders in the world use technical analysis as their tool. As we know, technical analysis is a technique using historical price data to determine or to forecast price movement in the future based on the premise that people will tend to repeat its decision based on similar condition. The more people applying this technique, it become self fulfilling prophecy.

For example, market sentiment is strongly down and Dow Jones Industrial index has already down 3% and heading to 8000 point. Fundamental factor also negative as the last few days most company announcing profit downgrade and millions dollar of losses. But suddenly once the index hit 8000, the market bounce back and setup a strong rally. Why ? Because from technical analysis point of view, 8000 is a strong support and many trader sitting on the fence waiting 8000 to be reach and they will jump in to market as a buyers that drive the markets up.

Technical Analysis factors is more important for short to medium term price movement.

Conclusion

In order to profit, a stock trader need to correctly determine the price movement of the stock based on 3 factors above (Fundamental Factors, Market Sentiment and Technical Analysis Factors) to fit his own time frame of investment. With good fundamental, in long term the stock of a company will go up in value, but other 2 factors will determine the shorter term price movement. Since nobody is able to predict the market consistenly risk mitigation / trading plan is more important than picking the right direction of a stock.

• As the term reveals, it started with buying some share in the share market. Say we buy 1000 shares of XYZ company for $10 each.
• Then we hold those share for long term: say 1 year, 5 years, 10 years or even more
• In the mean time we don’t do anything except ‘Pray’ (probably not even praying) and hope that the value of the share is going up. Say if after 5 years, the price become $20, then we make 100% of profit.

The money

Using this “BHP strategy”, investor make the money from 2 ways:

• Dividend income: only if the company distribute dividend
• Capital gain: when we sell the share and the share has gone up in value (the price has increased)

The problems

There are 2 big problems with this strategy:

1. What if the price go down ?
   You might argue, this is the risk that we want to accept…. OK, fine if you would. But what if there is a way to ‘insure’ your share…. That’s is: if the price go down, you’re guaranteed to still at least get your money back.
2. How to ‘lock in’ profit ?
   We see it often: the price of a share can be rallying to record high only to drop below buying price after sometimes. Is there any way when we fell like it, we can ‘lock in’ the profit, so we are guaranteed a profit even the price drop, but we don’t need to sell the share ? The answer is a bold Yes.

Better execution/alternative

So, if we can eliminate 2 problem above, would it make share trading far more attrractive? Imagine you buy share, got the dividend and the capital growth, but if the price go down you’re protected… and even more, once the price reach the high value, you can lock in the profit on that price. This is what smart investor does!

To find out more: read ‘Protected BHP: the classic with protection’