In a perfect call writing world, there would never be a need for closing covered calls early. Our short call options would all expire worthless and we would never have to think or worry about the issue.
Closing a covered call position early isn't necessarily a bad thing, however. In fact, in some situations, it can help you to either lock in the majority of your maximum profits ahead of schedule or it can be used as an option adjustment strategy to help manage the risk on your trade.
And if you're going to be serious about writing calls, the issue isn't about should you close a position early, but rather knowing when to close a covered call early.
Here are five situations where closing out a call before expiration might make a lot of sense:
How to Close a Call Early:
It's a question that comes up from time to time, so I'll address it here just to make sure everyone is on the same page.
Remember that when you set up a covered call you began by owning 100 shares of the underlying stock and then sold to open a call option at a specific stock price. This resulted in a short call option position.
[Note: when you buy the underlying shares and sell the covered call at the same time, the trade is technically referred to as Buy-Write.]
So closing a covered call before it expires is as simple as doing the opposite as you did when you initiated the position. Whereas before you sold to open, now you buy to close the short call, in effect canceling it out.
You would still own the underlying 100 shares but you would be free to either keep them or dispose of them as you saw fit.
I've addressed this issue elsewhere (see the related closing options early page), but sometimes the underlying stock makes a big move and you're left with a position where much if not most of the maximum gains have already been achieved (although unrealized as long as the position remains open).
The nature of options and time decay, if you'll recall, is that the closer an option gets to its expiration date, the faster its time decay. And that rate of time decay really begins to accelerate in the final 30 days.
So when selling calls, all else being equal, you would assume that the bulk of your profits would be realized in the time closest to expiration. Hence, it wouldn't make sense to close a covered call early, right?
But remember that while you're selling time as a call writer, on the other end of the trade isn't someone who's buying time per se, but rather the opportunity to participate in capital gains for a fraction of the cost of actually owning the shares.
So there are two different factors involved. And if the stock makes a big move higher, the remaining time value on your short call will plummet (the maximum level of theta, or the time decay component of an option's price, will be when the option is at the money).
Say I write an at the money covered call on a $30 stock with 30 days to go until expiration for $2 in premium. And then, a week later, the stock jumps up to $35/share.
Realistically, even though there's still 3 weeks left until expiration, because the call is now deep in the money, most of the option's value is intrinsic value (i.e. its theta portion has plummetted).
So maybe now there's only $0.50 of time value left until expiration (actually, I'm sure there would be a lot less).
So, in this example at least, I can get 75% of my maximum profits in 25% of the time by closing the covered call early (and selling the stock). In terms of total dollars, my net proceeds would be $3150 in one week vs. a potential $3200 in four weeks if I choose to hold the position until expiration and assuming the stock didn't fall back below $30/share before then.
In the end, it's going to depend on your own preferences, of course, but if, for example, you can lock in 80% of a trade's potential profit in, say, one-third of the time (vs. the original holding period), closing covered calls early really might be worth considering.
True, you might leave some money on the table, but one rule of thumb many traders use is to ask themselves if setting up what remains of the trade as a new trade would be attractive? If not, maybe there are better uses of your capital and time.
Of course, stocks can make big moves downward, too, and unless you truly are prepared to hold the stock for the long term, then another valid reason to close a covered call early is to cut your losses on the trade.
The premium you receive from selling a call will give you some downside protection (and the strike price you choose can give you a little more), but when a stock really craters, you'll still be hurt (just not as much as the investor who wrote no call).
If you're what I call a covered call income trader (your primary motivation is to profit from the covered call trade itself), closing your position early when the trade makes a big move against you will make a lot of sense.
If, however, you're a long term investor who sells calls incidentally, or are drawn to the more conservative Leveraged Investing approach, then holding tight and just allowing the call to expire worthless may be your best bet so long as you have a strong conviction in the quality and long term durability of the underlying business.
Closing covered calls early and taking a loss your trades just they trade moved against you might not always be in your best interests. After all, options are called options because that's what they give you.
Sometimes you're better off adjusting a covered call rather than just closing it out.
Maybe the trade only moves against you a little rather than a lot, or maybe there's a lot of implied volatility in the stock so that you're able to either roll down and out (preferable) or just roll out for additional net premium while you wait for the stock to come back.
A word of caution - hoping and wishing alone won't make a stock come back. That's why stock selection is so crucial when setting up a covered call trade (or any trade or investment for that matter).
Either way, when you roll a position, you're technically closing out the initial position and replacing it with a newer one.
Another reason you might want to consider closing a covered call early is in the case of dividends. In certain situations when an option is in the money (meaning that the current share price is above the call's strike price) and dividends are scheduled to be distributed, you might be facing an early exercise by the call holder so that he can collect the dividends instead of you.
Many beginning call writers worry a lot about early assignment (the call holder exercises the option which then gets assigned to you). In most cases this is a good thing since it means you've realized the maximum gain on the trade and ahead of time, too.
Of course, not everyone who sells a call on a stock actually wants to sell the stock. So an early assignment might mean something else for a long term investor.
It's pretty easy to determine whether you might see an early assignment. You simply compare the dividend value with the remaining time value of the option. If the dividend value exceeds the time value, there's a decent chance you're going to be assigned early ahead of the ex-dividend date.
Want to make sure you retain the dividend when writing a covered call? It's a pretty easy solution - either close the in the money call early or roll it out to a future month (where presumably the time value once again exceeds the value of the current dividend being paid).
Finally, another reason to close a call early is to avoid the potential volatility of an earnings announcement that takes place prior to expiration.
On the surface, it makes sense. Having an open covered call position during an earnings announcement exposes you to a lot of downside risk. Regardless of the analyst consensus numbers, there's always a lot of uncertainty and potential for (negative) surprises going into an earnings announcement.
And then, of course, there's always the uncertainty of the company's guidance for the upcoming quarter and/or remainder of the current fiscal year. Often, it's the guidance rather than the actual earnings numbers that has more immediate impact on a share's price.
But that also means that the premium level, (specifically the implied volatility) is going to be pretty high heading into the earnings call. So by closing early, you leave a lot of premium on the table.
I'm not saying that you should keep the position open through earnings, but it does beg an important question - should you have written the covered call in the first place?
You still may do well on the trade even if you do close the call early providing you wrote the call out of the money and the stock rises. But purely from a premium basis, your returns are going to be pretty low - that big anticipated event (earnings) is going to prevent the call from losing very much of its value until after the uncertainty has passed.
If you do well on the trade, it will be because the stock rose in value, not because of time decay.
KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares
Open Market Purchase Price: $20,071.83
Less Booked Option Income: $16,341.71
Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%