Thank you Dale for the question today:
“Since CVS has shot up above 70$, why don’t we just sell our shares now and take the profit?”
I like this question because while I’m aware that not everybody is following the VTS Discretionary Strategy actually covered calls in general is a trade type that I feel most investors should become familiar with. As far as option trading goes, covered calls are one of the most basic and commonly used option types out there.
I can’t tell you how many times I’ve gotten into conversations with people / other portfolio managers and they mention they also trade options. It’s always intriguing and it sparks my interest because there aren’t that many option traders out there. I don’t get that many opportunities to “talk shop.” However as the conversations go further you often find what they really mean is they trade stocks and occasionally sell covered calls against those positions. Not that there’s anything wrong with that, but it’s such a common trade that I hardly consider it option trading. It’s just investing. So becoming familiar with the basic covered call is probably useful for all investors.
So here’s what our current CVS shares / covered call looks like:
This trade is comprised of two parts:
1) 100 shares of CVS at a cost basis of 67.50
2) A May 67.50 covered call at a premium of 1.00
CVS is currently trading about 70.09$ so our 100 shares are actually up a fair bit. This is why the question was asked, why not just close it out now and take the money? Well the reason is because this is a two part trade and the dynamic would change dramatically if we sold the shares now.
If we sell our 100 shares for profit, that 67.50 covered call becomes a 67.50 naked short call.
That is an unlimited loss position that is essentially short CVS at 68.50. So what happens if CVS shoots up to 75, or higher? It was at 84$ just a few months ago. There’s definitely a time and place for naked short options, I sell them all the time in my own trading. However they have to be approached carefully with a keen eye on an exit strategy. I wouldn’t short CVS here so this trade must be treated as a single position with two parts that can’t be separated.
So when we do the math on the current position including both parts we see that our trade isn’t yet very profitable:
1) 100 CVS shares at a cost basis of 67.50.
(70.09 – 67.50 = 2.59 or 259$)
2) 1 x May 67.50 covered call @ 1.00
(1.00 – 3.48 = -2.48 or -248$)
We’re only up 11$. In order for us to receive our max profit we need to wait until expiry in 18 days. That was the original plan on the trade anyway and everything is going very well.
We started the Wheel of Fun with selling the put. When we acquired the shares we sold the covered call. Hopefully in 18 days CVS is above 67.50 and we can get paid to lose the shares and get back to cash. That would complete one full cycle of the wheel of fun. And if CVS rises substantially, perhaps we can do another wheel starting on the call side with CVS and go around again 🙂
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