Misinterpreting Data
One person who supports writing covered calls claims, "More than 75% of options that people hold until they expire end up having no value. That's why you should sell options to others like the pros do. Since most options become worthless, why not get some money for them now when they still have some value?"
Another advisor takes it a step further, saying, "Selling covered call options and cash-secured puts is a smarter move compared to buying options because about 90% of options end up expiring without any value."
The reality is, both of these beliefs aren't entirely accurate. The first person's idea implies that selling options without protection might be a good choice, but it's actually very risky. The second person's statement isn't entirely right either, but it does contain some truth. Many traders think it's better to sell options instead of buying them, but it's crucial to focus on reducing risks. In general, writing covered calls is a good plan for many investors, though it might not be as beneficial for short-term traders.
Many beginners in options trading find it rewarding when their covered call options expire without any value. It feels good because they still keep the stock, they've earned the option premium, and now they can write a new option to earn another premium.
However, this approach might lack foresight. For instance, if traders buy a stock at ₹49 and write calls with a ₹50 strike price, and then the options expire with the stock price remaining at ₹49, it might seem like a successful move. Yet, there are situations where traders focusing solely on options expiring worthless might make costly errors while waiting for the options to finish. These situations are rarely discussed.
There are two scenarios where traders who wanted their options to expire worthless might have made a big mistake while waiting for that to happen. Let's explore these less talked-about situations.
Feeling good about writing an option and having it expire without value can change if the stock price drops from what you bought it for. For instance, if the price falls from ₹49 to ₹41, it's not a pleasant situation. Even though selling the option reduced your losses, depending on how much the stock dropped, the option premium might not cover a significant part of your loss.
Now, if you still want to sell options at the same ₹50 price despite the ₹41 stock price, there could be problems. First, the ₹50 option might not be available anymore. Second, if it is available, the premium might be very low.
This situation poses a new question: Would you sell options at a lower ₹45 price, knowing that if the stock price recovers that much, you'd still face a loss?
This uncertainty in the future requires some investing experience to navigate properly. Ideally, managing the risk when the stock price falls below a certain limit would have been a better approach.
Option writers enjoy high implied volatility (IV) because it means they can earn more money from selling covered call options due to the higher premiums. Sometimes, these premiums can be so appealing that traders ignore risks and trade too many option contracts, causing issues with their positions.
Let's imagine this situation: You've sold a ₹50 call on a stock priced at ₹49 when there's sudden nervousness in the stock market, maybe due to a major political event like an election or Brexit.
Normally, you might be happy to get ₹150 to ₹170 by selling a covered call for a month. But in this hypothetical scenario with very high IV, just three days before your option expires, the call you sold is priced at ₹1.00. Typically, it's priced around ₹0.15. The price is unreasonably high, so you might choose not to buy it back and wait until the options expire.
An experienced trader doesn't just focus on the price of one option. They also look at the price of the option expiring a month later. When the IV is high, and they see the later-dated option trading at ₹3.25 while the near-term option is at ₹1.00, they might do something smart.
They could enter a trade to sell a call spread. This means they buy the near-term option at ₹1.00 and sell the next month's option at ₹3.25. By doing this, they get a credit of ₹2.25 per share, which is ₹225 in total.
Even though they might have to pay a higher price to cover the earlier sold option, what matters is the net cash they collect when moving the position to the next month. This cash, ₹225, becomes their potential profit for the upcoming month. This amount is significantly more than the usual income of ₹150 to ₹170 per month.
When a stock reaches the strike price of an option, it's highly likely that the option will be exercised. Usually, the option won't really "expire" at this point. The person who owns the call can buy your shares, even if the call is just ₹0.01 higher than the strike price.
The brokerage will close the option trade and take away the call from your account. The shares you had to cover the call will be sold at the strike price, minus any trading fees. Sometimes, this transaction might not show up in your account right away, but it should be updated by the start of the next trading day.
If your option ends without reaching the strike price, your brokerage will automatically close the trade and take away the option from your list of positions. You don't have to take any action for this to occur. For additional information, you can check your trade confirmations and account history.