Which Calls should I "write" .: Knowledge Base

There are numbers of advisers who advocate selling

(writing) listed call options against long stock,

especially highly appreciated stock which the

owner does not want to sell and incur a tax liability.

Selling calls reduces risk. And there is some evidence

that expert (and I mean true expert) selling calls

versus long stock may increase yield.

Let's suppose an owner of stock decides that selling

calls best fits his stratergy and attitude towards risk.

Two questions then arise: Which options are best to

sell and what does the seller do once the sale is made

and time passes?

Some advise selling out - of - the - money calls,

some advise selling at - the - money and some

advise in - the - money calls. Some like to sell the

near terms, some advise selling the LEAPs.

Some advise doing collars. Some advise doing a

combination of the above. Some, may even advise

selling "qualified covered calls" only. Given new

lower margin requirements, it may be wise to sell

calls that are at the money and sometimes in the

money.The correct decision is not a simple matter.

1. Perhaps you have heard that you should sell the most

overpriced calls, using theoretical models to locate those

most overpriced. But, maybe the most overpriced are the

very short term at - the - money calls which may expire in

less than a month. This would result in your being short an

option that will be either exercised and assigned to you within

the month. Or the options will expire worthless, thereby

requiring a new sale after expiration if you wish to remain

hedged. Calls that have less than 30 days when sold, can

not be "qualified covered calls".

2. Then there is the question of whether the calls that

you believe are overpriced are indeed overpriced.There are

informed traders who know that assumptions about the

expected distributions of stock prices are incorrect. This leads

to erroneous theoretical values. The general way of calculating

volatility is also suspect. Should you use one day or seven day

price relatives?

It may also be the case that insiders are trading on non-public

material information and have bid the calls up. Believe me, it

happens everyday in lots of stocks. I stood on the CBOE

and the PSE and watched it happen for ten years.

So just because an option is selling above a model's theoretical

value does not necessarily mean that the option is overpriced

or that it should be sold.

3. Then there is the question of the option's delta.

In-the-money calls have greater deltas and therefore require

the sale of fewer options to achieve the same delta hedge.

Selling in - the - money calls gives maximum negative deltas

but does not give maximum positive premium erosion.

4. One has to be concerned with the option's time to

expiration if generating income is the priority rather than

delta risk reduction. Also, selling long term options require less

transaction costs and less administration, which should

be an advantage to most hedgers. Of course the markets are

narrower in the nearer term options. So, the extra liquidity

gives an incentive to go shorter term.

5. The "writer" of calls may want to sell "qualified covered"

calls, because that will avoid the Straddle Rule under Section

1092 and allow him/her to "harvest" capital losses more easily.

Even though capital losses can be deducted against

ordinary income only to a maximum of $3000.00 per year,

and then against other capital gains (short or long term),

these "harvested losses" can be very valuable.

6. There is also a small concern that the hedge will cause a

constructive sale for tax purposes. But this seems easy to

avoid as long as you stay away from selling calls that are

highly in - the - money or doing collars or

conversions that eliminate all risk and potential gain.

7. You must also be concerned with how the hedge will

affect the taxation of any dividends the stock may pay.

This is not incidental where there is a substantial dividend.

8. Then after having made your decision to sell a particular

call, you are faced with the decision as to what to do when

time passes and the stock moves around.

9. Let's suppose the stock is trading at 60 and you sell the one

year calls with an exercise price of 60. Assume each call had a

delta of 61 when the sale was made. But the stock goes to 50

and there are now 6 months to expiration. The

delta of the short calls may now be only 21 making it such that

your delta hedge is substantially reduced. Do you sell more

options with a 60 strike or buy the 60's back and roll to longer

options with lower strikes and higher deltas. The proper

decision requires management and advice not generally

availiable.

10. So the whole process is not a simple matter and must be

understood and managed by experienced professionals.

11.The process becomes even more interesting when you use

listed calls to hedge un-exercised employee stock options.

Here, there is a very large advantage to avoiding the

premature exercise of employee options. Selling (writing)

LEAP calls perhaps is generally the best way to hedge

employee stock options.

Executives/employees owning ESOs should consider the merits

of selling (writing) LEAP calls of positively correlated stock to

avoid all the restrictions imposed on hedging ESOs by the use

of listed calls directly on company stock.

Writing listed calls ( or sometimes buying puts)to take

profits, reduce risk and delay taxes, is the only way to

maximize the after tax return on your ESOs.

12. Employers discourage this strategy as do most "advisers"

who are paid indirectly by the employer. Whether employers

discourage hedging for the purpose of keeping their costs

lower is a question which can not be answered by me at this

time. My guess is that few executives really understand the

ESOs but discourage hedging as that is what their advisers

tell them. Some claim that hedging ESOs reduces the

alignment of an employee's interest with the interests of

the company. That may be true but so does the

premature exercise and sale of the received stock. In fact

making premature exercises and selling stock eliminates the

alignment far more than hedging the options. Don't most

employees sell their restricted stock as soon as the stock

vests and doesn't the sale reduce the alignment?

Sure it does.

13. When should an employee write calls against his

employee stock options? He should write calls whenever he

wishes to reduce risk, starting soon after he receives the

grant. We have discussed the necessity of writing calls in