By Chris Ebert
Generally, Covered Call traders can eke out a profit even when stock prices are flat or fall slightly, because they collect a premium on the option upfront when they sell it. So, for example, if a stock is trading at $100 and a trader sells a Covered Call with a $100 strike price and collects a $5 premium, the stock price can fall $5 and the Covered Call seller will still break even when the option expires. He loses $5 per share on the stock but puts $5 per share in option premium in his pocket; it’s a wash.
The downside of selling Covered Calls is that the maximum amount the seller can keep as profits on an at-the-money option is the initial option premium. So, in times of intense rallies, the Covered Call seller gets some profit but the buyer gets an immense amount of profit. While it does not occur often, such is the case now in many stocks in the S&P 500.
Folks who sold Covered Calls on $SPY and many stocks in the S&P four months ago are watching stock prices skyrocket. The buyers of those options are reaping huge profits. The sellers are keeping only the small option premium as profit. It happens occasionally. But what makes this week different than the past is that the S&P 500 is further above the point at which a Covered Call trader earns a profit. That means the buyers of those options are profiting more than they have ever profited before.
Since Covered Calls can survive with a profit or at least break even in small downturns or corrections, they can serve as a barometer of the market as a whole. If one can’t make a profit when collecting a premium on a stock, it’s a good bet that sentiment among other traders has become bearish. But the current market has gone completely in another direction. The S&P is now 382 points above the area at which this weeks expiring $SPY Covered Calls ,opened at-the-money four months ago, would break even. That’s likely a new all-time record. That means the S&P could fall 382 points this week and the sellers of those Covered Calls back in November would still break even. That’s an amazing amount! Click Here for Historical Temperature Chart
Sure, the Covered Call sellers are happy, because they are getting to keep the premium they collected when they sold the option back in November. The buyers of those options are even happier because they have ridden a tremendous rally and will get tremendous profits when they exercise the options.
But there are other implications to consider. Covered Call sellers have mostly missed out on the recent rally, except for the premiums they collected. Call buyers are now ending up in a position, when they exercise their option, of owning stock that has appreciated considerably. This changing of hands can do strange things. The Covered Call sellers may be envious and want to get back into the market by buying stocks. The Call buyers may not want to push their luck, and may want to sell their stock and laugh all the way to the bank. Since the S&P has never reached a Temperature this high, at least in the past several decades, it’s difficult to know whether the sellers or buyers will have a greater influence, and what effect the changing of hands might do. We are now in uncharted waters.
The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca
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