Covered-call income when implied volatility is cheap

A two-month covered-call income procedure

A covered-call income procedure starts from stock already owned and sells a call about two strikes above the market with roughly two months remaining. Covered-call writing is that sale: the premium is income, and the shares can be delivered if the call is exercised.

An option income strategy is a repeatable procedure that turns entry, exit and abstention into one testable income routine rather than a one-off trade. In this routine the holding period is the two-month life of the written call.

The live premium versus the model

In the worked case the stock is at 101 with a volatility of 35. A model prices the candidate call at about 2.64 to buy or 2.16 to sell, with 52 days to expiration and a 25 percent chance of finishing in the money.

The same call is actually quoted at 2.20, which implies a volatility of 33.5. Implied volatility is the volatility the live option price implies, used to judge whether a quoted premium is cheap or rich versus a model. On that comparison the option is a little cheap to buy and slightly unfavorable to sell.

Assignment, expiry and a stock decline

If the call is assigned, the writer still receives 110 for the stock plus the 2.20 premium. If it expires worthless, the same two-month sale can be repeated.

A decline from 101 is only partly offset by the 2.20 premium, so the covered call reduces but does not eliminate stock loss.

Calls, puts and moneyness

Calls and puts are the only two contract types. A call is the right to buy a fixed share lot at a fixed strike by a fixed date, and a put is the right to sell that lot on the same terms. The strike price is the fixed price at which the option can be exercised. The expiration date is the fixed last day the option can be exercised, conventionally the third Friday of the listed month.

Only the holder may choose exercise. The holder is the long option owner who alone decides whether to exercise. The writer is the short option seller obligated to perform if that choice is made. The long side can instead sell the contract or let it expire.

Moneyness is the strike-versus-stock relationship. Equal prices are at the money. A call with strike well below the stock is in the money. An out-of-the-money option is cheaper to replace in the cash market than to exercise.