As I’ve mentioned previously, my wife and I are looking into using a covered call strategy to try and boost returns in our portfolio. So yesterday I spent some time running through a few trading scenarios to see whether there are some trades we should be trying to make. Here’s the process I ran though, and my logic of why it was the right thing to do. Please feel free to comment and let me know if you think we’re making bad decisions!

Our current plan is to make income that effectively lowers our cost basis in a position while not limiting our upside too much. For now, we are thinking no upside limit less than the equivalent of a 20% APY since we view the positions we’re talking about as good long term investments. (Later, after our GI portfolio gets big enough, we can try out options trading purely for income.) To find trades that fit this goal, we need to filter all possible call option trades down to those that have a maximum profit potential of greater than 20% APY, and then pick the one that allows us to collect the highest premium for making the trade. i.e. the one for which we collect the most money for selling the call option. So how did we figure out maximum profit potential?

To start with, I randomly picked one of our investments, VEU (a Vanguard All-World, ex-US ETF), and looked up its associated option chain. For those who don’t know, an option chain is a listing of all currently tradeable options associated with a given underlying security. It is typically shown as a table where each row corresponds to a single option, and thus to a single combination of strike price and expiration date. e.g. one row for UENIF which is the call option for VEU that expires on Sep 19, 2009 with a strike price of $32.00. The columns in the table typically show at least the following information about each option:

- Price at which the last trade was completed (not necessarily traded today though!)
- Current bid (the highest price someone is currently willing to pay to acquire the option)
- Current ask (the lowest price someone is currently willing to sell the option at)
- Volume (the number of trades of this option in the current trading session)
- Open interest (a count of how many of this option are currently being held by someone in the world.)

The useful numbers for our maximum profit analysis are the strike price itself and the bid number (because we’re selling calls, we only care what someone will pay to buy them from us.) Given those, the maximum is relatively easy to figure out because the profit can consist of only two parts once you’ve made the trade. The first part, the premium collected by selling the option, is fixed by the trading price of the option itself. And the second, the profit made on the underlying security, is limited by the strike price of the option (because it will almost certainly be exercised at the strike price if the market price goes above it.) Add the profit from these two aspects together and you get the maximum profit. Simple, right?

As an example, consider the option UENIF, which is the September 19, 2009 expiration for VEU at a strike price of $32.00. When I checked yesterday, the bid on this was approximately $1.25 which means that someone would pay me $125.00 to buy a single option (they pay $1.25 for each share in the option and there are 100 shares in a single option.) Subtract from that the comission on selling the option, let’s say that is $10.00, and the premium being collected is $115.00. To that I want to add the profit from when the option gets exercised. Let’s assume my cost basis for my 100 shares of VEU is $31.00. Since the option’s strike price is $32.00, I’d make $1 per share, or $100 profit, on the exercise. Of course, I have to subtract off the trading commission on that too (assume its $10 again), so my real profit is $90 on the exercise. Which means that my maximum profit for this call option is $205.00 ($115.00 plus $90.00). That is a maximum return of 6.61% because I’ve earned $205.00 on a cost basis of $3100.00 (100 shares of VEU at $31.00). And, since expiration is 239 days away from yesterday, that means a maximum profit equivalent to an 11.87% APY. This is lower than our filter level mentioned above (20% APY) so we wouldn’t consider trading this option.

Let’s try it again, but this time use the option UENFH, which is the June 20, 2009 expiration for VEU at the $34.00 strike. When I checked yesterday, the bid on this was only $0.35 so I’d only collect a $25 premium on selling the option. ($0.35 x 100 shares = $35.00, minus a $10 trading comission.) However, the profit on the underlying stock would be $290 since my cost basis is the same $31.00 as before. ($34.00 – $31.00 = $3, times 100 shares is $300, minus a $10 trading comission.) This gives me a maximum profit of $315, which is a 10.16% return on my $3100 cost basis. Since expiration is only 148 days away from yesterday, that means a maximum profit equivalent to a 55.12% APY. Way above my minimum 20% APY level! But the actual premium is only $25 in the event the option doesn’t get exercised. While I wouldn’t mind that $25, I suspect its lower than I could get by finding an option that comes in with a maximum profit closer to our 20% APY value. However, I’m not positive on that and there could be any number of factors involved that I don’t know about yet. For example, the small volume of VEU options trades, macro forecasts I’m not aware of, important news I haven’t seen yet, and so on.

Unfortunately, running these calculation for each option takes a bit of time and it took me a number of tries to identify even one that passed the 20% maximum profit filter. I ended up running out of available time before I could find one that had a good balance of premium collection vs. maximum profit potential, and thus I didn’t enter any option trading orders yesterday. Not to mention, I haven’t done enough of them to even begin to see any patterns that would give me a clue as to whether that $25 is a “good” trade or if I should hold out for a better deal. I’ve either got to find some software to do it (i.e. a brokerage site with tools, a third-party site, etc.) or write my own (I’m a programmer so that shouldn’t be too difficult.)

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2 davmp // 2011.01.17 at 7:50 am

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