posted on 11 March 2016
by Russ Allen, Online Trading Academy Instructor
Recently, I wrote about using options as a way to buy stocks or exchange-traded funds at a discount. Today we'll look at doing a similar thing but in reverse. This gives us a way to sell stocks or ETFs that we own at premium prices.
Since we've been using the gold ETF (GLD) as our example, let's continue with that. Here is the chart of GLD as of March 3, 2016:
Suppose we owned 100 shares of GLD. We have seen it make a nice run up, and against a recent high around $120, we think this is a good place to take a profit. We believe (let's say) that it is likely to remain above the demand zone around $114, but could take a breather. We want to lock in some profits.
One way to go about this would be to sell an in-the-money covered call option. This could work like this:
The March 31 (quarterly) $114 calls could be sold at this time for $7.73 per share. Meanwhile, at $120.73, the price of GLD exceeded that $114 strike price by $6.73. This amount was the call's intrinsic value. Subtracting that $6.73 of intrinsic value from the call's price of $7.73 gives a difference of $1.00. This $1.00 was the call's time value.
We would be allowed to sell the call short because we already owned the stock that would be needed to satisfy our obligation to deliver the stock if the option was exercised. No additional margin deposit would be required to sell the call.
The two parts of the position - the long stock plus the short call - make up an in-the-money covered call. We would now have an obligation to sell the stock for $114. We could expect this to occur on the March 31 expiration date, as long as the GLD stock remained above $114 at that time (which we believed would happen). If it did, we would at that time be paid $114 per share for the stock. Adding to that the $7.73 we had already been paid for the call option, our total take would come to $121.73.
That amount was $1.00 more than the current price of the stock. We will have sold a stock worth $120.73, and received $121.73. Through no coincidence, the extra $1.00 that we will have netted is the amount of time value that was in the calls when we sold them.
This is a nice way to juice up our selling price for a stock. It does carry a certain amount of risk, however. If GLD should drop in price below the $114 call strike and remain there at the March 31 expiration, the call will not be exercised. We will then still own the stock.
This is not necessarily a bad thing unless the stock drops too far. Let's consider our cost of GLD to be the $120.73 price that we could have had by simply selling the stock instead of doing this covered call. Since we already received $7.73 for selling the call, we have in effect reduced our cost of GLD by that much. We could say that our adjusted cost is $120.73 - $7.73 = $113. As long as GLD stays above that $113 level, we will still have improved our situation. And if it doesn't, there is always next month and another in-the-money covered call to sell.
This is another demonstration of creatively using options to enhance profits on stock positions.
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