By: Steve Smith
Peterffy noted that the recent options trading volume increase is predominantly being driven by retail traders buying out-of-the-money calls. This demand for upside exposure — especially in names such as Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), and Tesla (TSLA) — have reconfigured the skew of options’ prices. Simply put, call options are now more expensive than put options; a highly unusual situation. Even more unusual is Peterffy’s statement that IBKR customers are now net short of the market; something that’s never occurred in the firm’s 40-year history.
The reason for the respective net shortage isn’t because they’re necessarily bearish but because they’re selling the calls that those retail traders are buying to collect the pumped-up premium.
Most people chiming in on Peterffy’s interview are glossing over IBKR traders — who tend to be more sophisticated professionals — hedging the sale of those calls by purchasing stock. In essence, creating a covered call. The overall positions may look net short because these traders aren’t creating the covered call on a strict 100 shares to one call contract structure. They would be hedging based on delta. Meaning, they may only buy 50 shares to hedge the sale of one out-of-the-money call.
Again, the important point is that these savvy traders are seeing a unique opportunity to create attractive covered call positions due to the pumped-up premiums being created by the huge demand from retail traders for out-of-the-money or ‘lottery ticket’ calls options.
With that said, let’s drill down into how and why covered calls are so popular. When a trader writes a covered call, usually they’re looking to sell theta decay, a component of premium. They often will not consciously understand that. However, when quizzed, that’s generally their objective. Selling premium can mean many things. But for this purpose, we mean selling extrinsic value; the option price component most influenced by time passing by, the underlying symbol price changes, and the buying and selling pressures of the option itself. Intrinsic value, the other option price component, is that actual option value at expiration; the real tangible value. The intrinsic value’s only a function of the underlying symbol price and the option type (call or put). The intrinsic value of an at-the-money or out-of-the-money option is zero.
Near-term premium is what’s most often sold. Here’s a graph showing how the value of the premium isn’t time linear. An option will lose much less value over a day passing when it’s 60 days from expiring than when it’s five days. The risk with covered call writing is that the underlying symbol will appreciate, causing the option buyer to exercise it, or worse, depreciate, leaving the seller with a premium against a devalued underlying symbol. Selling near-term premium optimizes the highest selling price with the least amount of time to wait for that price to decay. Our intention’s to buy our call option back at a much lower price. Or, let it expire worthless.
Note, time decay or theta is not linear, it accelerates as the expiration date approaches. The intention to sell multiple premium cycles against the underlying stock.
Every cycle you sell premium against the underlying expires worthless, lowering your investment. The prior cycle profit’s subtracted from your investment. The current cycle profit over the lowered investment exponentially increases your Return on Investment (ROI) capital. Each subsequent cycle, you have a lower cost basis while collecting option premium income and dividends payout.
AAPL aside, some other blue-chip stocks one might consider for covered calls include Microsoft (MSFT), Wal-Mart (WMT), and McDonald’s (MCD) which all have solid balance sheets and pay a decent dividend. They’re likely to emerge from this crisis with an even greater market share.
Those that want to be a bit more speculative might look at energy stocks, which have been decimated. For example “Exxon (XOM),” which is down some 60% in the past two months, now offers a 10% dividend yield.