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Covered Calls in the Fast Lane: Ladder Price, Volatility, and Time

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September 28, 2016
laddering covered calls
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Prices discussed in this article exclude commissions and transactions costs.

What's cooler than leasing your stock to someone while giving them the option to buy it at a higher price? Not much if you’re a buy-and-hold investor. But if you’re a trader, you probably already know that this is nothing more than a covered call—and that might put you to sleep at the wheel, if you’re looking for excitement. So what makes covered calls—a combination of long stock and a short call—swerve left and get in the fast lane? Buckle up and let’s find out.

Most U.S. equity options control 100 shares of stock, which is another way of saying that they deliver 100 shares at expiration. So, if you’re short a call at its expiration and you’re assigned, you have to deliver 100 shares of the underlying stock. This will happen if your short call is in the money (ITM), and in all likelihood, at the money (ATM) since a short contract can be assigned at any time regardless of its ITM or out of the money (OTM) amount. If you don’t deliver 100 shares, you’ll be short 100 shares of the stock the day after expiration—which may or may not be what you want.

In a covered call, the long stock leg is the hedge that offsets the delivery on the short call. If one short call is covered by long 100 stock shares, two short calls are covered by 200 stock shares.

So, having 100 stock shares means you can only sell one call, and that one call has to be at one strike and one expiration. But “laddering” is a technique you can use to cast a wider net when you have 200, 300, or more stock shares.

Climbing Ladders

Laddering means selling covered calls at different strike prices, or expirations, or both—against more than 100 shares of long stock. For example, if you’re long 300 shares of XYZ at $75, laddered covered calls could be short one December 76 call, short one December 77 call, and short one December 78 call. That means you’re short a total of three calls covered by the long 300 shares. On the other hand, laddered covered calls could be short one 77 call in a December expiration, short one 77 call in a January expiration, and short one 77 call in a February expiration. Again, you’re short a total of three calls covered by the long 300 shares.

Let’s break down a few different ways to ladder the covered call.

Ladder Across Strikes

The first approach for laddering covered calls means you sell them at different strike prices. Consider the basic properties of a covered call. A short call limits the upside profit potential of the long stock to the call’s strike price. If you buy, say, XYZ at $75 and sell the 77 strike call (for $0.75), the long stock makes money when the stock’s price goes up. But over $77, the profits on the stock are offset by losses on the short 77 call when in exchange for limiting the stock’s upside, the covered call reduces the stock’s breakeven point by $0.75 to $74.25.

Laddering the strikes of short calls adds more flexibility. Against 300 shares of XYZ, selling one 76 call for $1.25 limits the profits on 100 shares up to $76, but reduces the breakeven point for those 100 shares to $73.75. Likewise, selling one 77 call for $0.75 limits the profits on another 100 shares up to $77, but reduces the breakeven point for those 100 shares to $74.25. Selling one 78 call for $0.50 limits the profits on the final 100 shares up to $78, but reduces the breakeven point for those shares to $75 – $0.50 = $74.50.

To calculate the net effect of laddering, take the averages. You sold three calls for a total $2.50 credit. So, each call was sold for an average of $0.833. The average breakeven point for the stock is $75 – $0.833 = $74.167. And the average stock price above which the long 300 shares won’t make money is $77. In this example, laddering across the 76, 77, and 78 calls took in a larger credit and created a lower breakeven point than just selling three 77 calls for $0.75.

That won’t always be the case, as the prices of OTM calls will vary with differences in the implied volatility skew. But laddering lets you adjust the breakeven and max-profit point for a covered call strategy to match your outlook for the stock.

How? Are you more aggressively bullish? Laddering to further OTM calls gives the covered call strategy more upside potential, but a higher breakeven point. Are you more concerned about the downside? Laddering to calls closer to the money can reduce the stock’s breakeven point, in exchange for less upside potential.

You could roll three calls at a single strike to a higher strike in the same, or different, expirations in one spread transaction. For example, buying three 77/78 call verticals could roll short three 77 calls to short three 78 calls. Rolling laddered calls would involve more transactions, e.g., rolling the short 76 call, rolling the 77 call, and rolling the 78 call, which means additional execution risk and potentially higher commissions.

What’s the downside? First, it can be harder to execute laddered covered calls than to sell covered calls at the same strike. Unless you sell the calls at the bid price, you would be, in our example, working limit orders on three different calls. Further, you might not get filled on all three at the prices you want. That’s also true for buying the calls back, if you wish to do so. Second, the commissions may be higher when executing three separate orders versus a single order for three calls. And third, rolling and managing three calls at different strikes can be trickier than for three calls at one strike.

Laddering Across Expirations

Another approach involves selling covered calls at different expirations, which can add an element of time to the covered call strategy and be useful when important events rise, such as earnings. Earnings can elevate the implied volatility of options in the expiration following the announcement because earnings uncertainty can make traders think a stock price might have bigger moves, which drives implied volatility higher. Look on the right-hand side of the Trade page of the thinkorswim® trading platform by TD Ameritrade to review implied vol.

implied volatility

FIGURE 1: IMPLIED VOLATILITY AT A GLANCE.

Select the Trade tab and you’ll see the overall implied vol for the options contracts listed on the right-hand side. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.

For each expiration, there’s a single, overall implied vol metric for the options in that expiration (Figure 1). If you see one expiration’s implied vol is higher than the ones before it, there’s a good chance earnings are expected shortly before that expiration.

All things being equal, when implied vol is higher, an option’s price is often higher, too. The same goes for longer time to expiration. Laddering covered calls across expirations can mean you’re capturing higher premiums because of higher volatility around earnings, as well as higher premiums because of more days to expiration.

Why wouldn’t you just sell the covered calls in that expiration if the implied vol is higher? Because you’re risking the stock having a large move from that earnings event, which will affect your covered calls adversely.

Think about laddering across expirations to diversify around the event. Let’s say XYZ (still at $75) has earnings just before a January expiration. Laddering covered calls against 300 shares of XYZ might be selling one December 76 call, selling one January 77 call, and selling one February 78 call. The premium you get for selling the calls in the January and February expirations is higher for two reasons. One, you have more days to expiration over the December ones. Two, you have increased implied vol in the January options because of the earnings.

Additionally, laddering across expirations is a way to balance short calls that have higher positive time decay (the ones at the nearest expiration) with those that have more time premium (the ones at further expirations).

What’s the downside? In addition to the execution risk, potential higher commissions, and management issues, another risk of laddering across expirations is that you have to hold until the expiration of the furthest short call, unless you close the position by buying the short call back and selling the stock. You could choose to maintain your long position. Either way, the extra time you’d hold the stock can increase the risk of the stock dropping sharply below the breakeven point.

If laddering sounds good ,but you’re trying to wrap your head around how to get all those trades executed at the same time, thinkorswim has a tool that lets you send orders for laddered options simultaneously—the “Blast All” order type (see the sidebar).

Ultimately, laddering means using the same old strategies like a covered call with more flexibility. That’s why the fast lane could turn out to be a pretty familiar road.