After the farmers plant their crops they watch over them making sure they have plenty of water, the weeds are removed, and insects
are controlled. They still realize that even with all this effort the success of the crop is still dependent on the weather and other things they cannot control. The same concept is true of a covered call position. Let's do an example.
I decide that I like Riverbed Technology (RVBD) after reviewing the fundamentals, the IBD composite score, the industry reviews, etc..
Since I prefer longer calls I decide to buy 100 shares of RVBD ($54.00 on 10/22/2010) and write a January 2012 $55.00 call ($1,055 premium). My net cost is $4,345 so my actual premium % is $1,055/$4,345 or 24.3%. Since it's approximately 14 months til expiration the per annum premium is 20.8% which meets my expectation of 20% per annum for Longer calls.
Note: This is not a recommendation for RVBD but a real example for calculation purposes. You need to do your own research on any buy/write for your personal account and understand the risk of investing in any stock before you proceed even with a covered calls strategy.
So what can happen with this position:
1. The Harvest. I define the harvest both as the stock being assigned because the stock price is above the strike price (a full harvest) at expiration date or the stock price is below the strike price and the call expires worthless and I still lock the premium as profit on January 21, 2012. In the latter case I still own the stock. (NOTE: An Early Harvest normally can occur when the stock price is higher then the call strike price. If it is below you have a loss on the stock and I don't consider this a early harvest. You need to decide how you define this difference....Again, stock must be in a profit situation before I consider an EH.
I will develop in more details considerations about the proceeds of the harvest in the "replant/rotate" tab and what you can consider if you get storm damage in the storm damage tab.
2. The Early Harvest: (EH) When I first started doing covered calls I always thought I would just wait until the expiration date and
the stock would be assigned or calls expire worthless. I knew I had to develop rules for handling the unexpected storms.
About 6 months after starting the strategy my friend Ira and I were having lunch one day and for some reason we started questioning why we would wait to take profits and close positions until expiration dates if we could capture profits earlier and have a higher chance of making a greater annual return.. So, on a day off from work I reviewed all my open positions and was amazed how many I could close early and do a new buy/write that could actually increase my return.
As I generally write longer calls it reconfirmed my strategy because not only was I getting considerable downside protection, but now found a way to actually close earlier and make some very high annualized returns. This assumed I could do another buy/write that resulted in more profits when I added the closed position profits and the new position profits together vs. waiting for the original harvest.
It really started making a lot of sense to close them early if they met certain requirements. Here is my thinking:
1. You are in the money and the max profit has already been achieved (not realized until expiration) but you have to wait until expiration to lock it in. What happens if the stock falls way below the strike price and while you make money on the expired call you lose on the stock position. A current funny GEICO commercial discusses "it is better to take the bird in the hand vs the two in the bush". Same idea.
2. You have to make sure that you can make more profit in a new buy/write then the MLOTT (Money Left On The Table). For example, let's say that RVBD goes to $90.00 in the next few months (I hope). As a stock goes deeper in the money the time premium portion of the overall call premium normally declines. This decline is the key to being able to EH and make more money.
Hopefully, you have a good understanding of Intrinsic value of a call (In the Money) and the Time Premium portion. Very important
Ok, if RVBD goes to $90.00 the January 2012 $55.00 call will be at least $35.00 of intrinsic value (in the money).
Let's say the time premium is $5.00. Thus, the total call price would be $40.00 or $4,000 to close.
I have another close friend, Farmer Paul, who collaborates with me nearly daily on the strategy and we have set some rules on when we will consider an EH based on how much of the maximum profit we can capture now. The most I can make on RVBD on assignment is $5500 - net cost of $4,345 = $1,155. The max premium on a call expiring worthless is $1,055 so I'll use the higher for my calculation which is $1,155.
Our current guidelines for EH are:
If a Leap or longer call I want to capture at least 50% of the maximum profits: $577 in this case.
In the example above if we sold the stock for $9,000 and it cost $4,000 to buy back the call we would net $5,000. The
net cost of the position was $4,345 or a current profit of $655.00. So, if I capture $655.00 out of a max profit of $1,155 it would be
56.7% and based on my target would become an EH candidate. The current profit of $655 represents an actual return of
15.1% ($655/$4,345) or 60% per annum if 3 months.
If a shorter call would like to capture 75% of the maximum profits. These are not hard % and can vary depending on the initial premiums vs today's premiums and other factors, but a guideline.
So in our example the MLOTT would be $500.00. Thus I would need to make $500 with the net proceeds of the sale which
is $5,000. So, can I make more then 10% + between the time I do the EH and the end of the original call period? If we
were to do the EH today could I make the 10% actual in the next 14 months. Since I did a number of January 2012 calls
yesterday and got over 20% the answer would be yes. In this example I would do the EH.
Now, here's the risk and wild card you need to consider. Let's say I take the proceeds and buy into one or two stocks and get 20% actual. What happens if both stocks tank between now and the end of 2011 while RVBD goes to $300 a share. Well, you never know and this is the wild card. You must be comfortable with your stock selections. Nothing is 100% guarantee. I have been happy with my results following this approach but understand there are risk with this and any
strategy. On the other hand, RVBD could go down to $30.00 and the new positions are both assigned. Again, decide your level of risk with any strategy.
An example of a process to arrive at the decision is shown on the right.
1. Determine the net cost of the position: Cost of stock less Premiums Received = NCP
2. Determine Maximum Profit if stock is assigned: Call Price X number of shares less cost of position = MP
3. Determine Premium Profit if expires worthless = PPW
4. Determine net amount received if you close the position now: Proceeds from selling the stock less the cost to close the open call = NETNOW.
5. % of Profits Captured = PPC
6. Meet target of 50% for LEAP/75% shorter?
Example: YES Proceed with review.
8. % Actual return needed to break even = PRN
Example: 10% +
9. Can I do a new buy/write and make more then the PRN?
Example:YES, based on a review of current buy/write available.
10. Make the final decision if you want to EH the position.