The Biggest Risk of Writing Covered Calls - InvestingChannel

The Biggest Risk of Writing Covered Calls

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Top Stock Searches in the Last 7 Days

Rank Name Searches
#1 Tesla 352,370
#2 Eversource Energy 167,258
#3 Netflix 141,881
#4 Apple 123,960
#5 AMC Entertainment 100,832

It’s no surprise that Tesla (TSLA) ranks first over the last week in our Trackstar database gauging investor interest. 

The company reported earnings last week. 

It beat expectations on profits but missed on revenue. However, its automotive revenue rose 55% year over year and 28% between Q2 and Q3.

Rather than rehash earnings again, The Juice prefers to focus on how we can be better investors

Last week, we made a hypothetical covered call options trade on TSLA ahead of earnings. We promised we’d be back to review what happened and how it can affect a position in TSLA. 

Note the huge earnings-induced drop in TSLA’s share price, from $222.04 at Wednesday’s close to around $204 shortly after Thursday’s open. Then, the run back up was good enough for a 2% gain over the five days bookending earnings. 

This matters to our covered call scenario. 

But first…

Why Write Covered Calls? 

The typical answer: You think the stock you own will stay flat, fall in price, or moderately increase in price. So you’re neutral to bullish. 

Makes sense. But some investors routinely write covered calls against stocks they own for income. Irrespective of sentiment. 

For a refresher on covered calls, see this past installment of The Juice

For the lowdown on what happened with our TSLA covered call, scroll with us.

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The Elon Option

Key Takeaways:

  • Tesla’s reaction after earnings complicates our covered call. 
  • But it lets us highlight two key tenets of call options as they relate to writing covered calls. 
  • Writing covered calls is a low-risk, not no-risk, strategy. 



Source: Optionistics

This chart says it all about one key tenet of covered call writing: Implied volatility (IV) tends to decrease, if not outright crash, post-earnings. 

We defined IV in last week’s installment where we made the following hypothetical trade on the Friday (October 14) before Tesla’s Q3 earnings:

[W]ith TSLA trading at $204.99 as of Friday’s close, we could sell the Nov 18, 2022, $210 call and collect a premium of around $16.50 a share, or $1,650 (because each option is for 100 shares). We’d keep that $1,650, no matter what happens to TSLA stock. 

Follow the red line on the chart and you see IV declined significantly, along with the premium on our TSLA call options (blue shaded area), after Tesla’s earnings. 

Two thoughts: 

  • Initially, our trade looks good. We sold a $210 call and collected $1,650 in premium income. TSLA declined to about $204. A textbook case of what you want to happen. More on that in a second. 
  • But we jumped the gun buying our calls on the Friday before a Wednesday earnings report. As the chart below shows, had we waited until Monday, Tuesday, or Wednesday (the 17th, 18th, or 19th) we could have really taken advantage of the IV spike and collected income in excess of $2,000 when the premium was in the $20 to $26 range. 

Source: Optionistics

Our little “mistake” works out well for illustration purposes. 

Generally, IV progressively spikes leading up to earnings, typically bringing call premiums with it. After the report, IV tends to decrease, if not plummet. 

Even when a stock moves higher post-earnings, IV can crash. We’ll save that scenario for another day, as it brings other factors, such as time decay, into the equation. 

Now, another key tenet: When you write a covered call, you run the risk that a buyer will call away your shares. Always keep this in mind, especially if you don’t want to lose your shares. 

Remember, when you sell a covered call, you give the buyer the right to purchase your shares at the call’s strike price on or before the option expiration date. In this case, $210 on or before November 18. 

Right after earnings, you’re sitting pretty, as TSLA tanked to $204. 

In a perfect world, the stock stays below $210 and you don’t have to worry. 

Of course, the world isn’t perfect, particularly when you’re dealing with volatile stocks. 

As the following chart shows, as TSLA rebounded and recovered after its initial earnings decline, the value of the call we sold also increased, moving as high as $17.97. 


Source: GoBull

In this case, you haven’t lost anything. Yet. 

You still have the $1,650 you earned from selling the call before earnings. But if TSLA roars back toward and beyond $210, as it did, you risk having to sell TSLA for $210 regardless of the market price. 

With TSLA trading at $214 (to make it even) as of Friday’s close, you would’ve missed out on $4 in upside per share. But because you sold a $16.50 call, you have cushion. 

You technically don’t leave money on the table in this trade until TSLA passes $226.50 (the $210 strike plus the $16.50 call premium). 

And we don’t know how much you bought your original TSLA shares for. If you paid $100 and had to sell for $210, you profited all the way from $100 to that $226.50, including your premium income. 

The only way to undoubtedly avoid having your shares called away is to buy back the call you sold. 

However, as the charts make clear, this would significantly cut into the $1,650 you collected. It could even result in a loss. 

If you were able to buy back the call for $15.00, you would’ve had to pay $1,500 for 100 shares. You keep your shares but end up netting just $150 for your troubles (the $1,650 you originally collected minus the $1,500 you paid to buy the call back). 



The Bottom Line: We highlighted the perfect-world scenario of TSLA dropping post-earnings. Then, we introduced the problem of TSLA rebounding, which jeopardizes your stock position. We’ll leave things here for today. 

In our next installment on covered call writing, we’ll expand on buying back a call to avoid having your shares called away. We’ll also introduce the concept of time decay and how it can affect an option price and this strategy. 

For now, know it’s best to sell calls when IV is high, often right before earnings. But you risk having to sell your shares for below market price if the stock takes off on you.

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