Covered Calls; What Do You Do If The Short Call Expires Worthless

Covered calls are the easiest and perhaps most effective method for the average investor to capitalize the options market. Selling a call against a stock you own provides a stream of income, can lock in profits and even be used to hedge a position. If you go on the internet you will be able to find hundreds, if not thousands, of articles and websites dedicated to the subject. For the most part these articles are focused on what a covered call is and how to choose one. A few will go on to discuss the need to monitor, and how to monitor, but very few go into much detail about what you should do in the case your sold call expires worthless.

I can remember clearly my first covered call. I was excited to have learned the strategy, pleased with myself for finding what I considered to be a great trade, was elated when my option expired worthless, hopeful when I sold the second call and then completely crushed when the bottom fell out of the market for the underlying asset.

Covered Calls: Two Possible Outcomes

The goal of a covered call is two-fold; the primary goal is to produce cash flow and income, the secondary goal is capital appreciation. You create cash flow by collecting the premiums, you achieve capital appreciation when the underlying stock gains value and is sold at a higher price. Once purchased there are two potential outcomes, the stock will be called away and you will receive the max return for the trade or the option expires, you keep the underlying stock and earn only the premium.

Most stocks are optionable, all of them are available to be used for covered calls but not all of them offer the same returns. The ones with the highest returns are often supported by underlying fundamentals and/or an expectation for a rise in the price of the underlying asset. As the market's expectations rise, so to will implied volatility and by extension the value of the option thereby providing an attractive covered call investment. If you are lucky market expectations will be met, the stock will rise and you will be called out. If not, expectations will not be met, share prices will not rise, you keep the underlying and are free to sell another option.

What To Do When Your Covered Call Expires Worthless

At face value it may seem like you would want your call to expire worthless. You get to keep the stock and you can turn around and resell another call the next month, creating another opportunity for a 3% to 5% gain. In my experience this does not always work. In the case that your option expires worthless you will be faced with a big decision, keep the stock and resell the option or sell the stock and move on to another trade. In order to make this decision there are a few things to consider including market expectations and volatility, particularly implied volatility.

Implied volatility is one of the most important factors in the pricing of options. A change in IV can dramatically affect the price of an option regardless of the movement of the underlying asset and is often the deciding factor when considering which option strategy to use.

If the option expires worthless because the expected catalyst did not yet happen, or the corresponding market movement is yet to occur, then you are most likely OK and free to sell another option. If the option expires worthless after the expected event, expectations were not met and/or did not spark the expected movement in the underlying asset there is a strong chance the price of the underlying will fall sharply, if not now then soon, resulting in a net loss. If this is the case then selling the underlying asset and moving on to the next trade is probably a good idea.

Five things you need to know when considering the sale of a second covered call; original cost basis, adjusted cost basis, option premium, potential returns if called out/not called out and potential market catalysts.

Why sell the underlying? Assuming the stock was purchased expressly for selling covered calls you do not want to lose your original capital, after all, capital preservation is a primary rule of account management. If the underlying asset did not meet expectations it is likely the traders who helped support share prices and drive up implied volatility will help to drive down share prices as they exit the trade. Additionally, a failure to meet market expectations could cause a drop in implied volatility that will lower the prices of all options in the series, negating the attractiveness of the investment, regardless of the price of the underlying.

The Bottom Line

The bottom line is that covered calls are a great way to trade options. They provide income, cash flow, capital appreciation and are relatively simple compared to most other options strategies. The caveat is that simple does not necessarily mean easy and you could end up with much larger losses than anticipated.

I'll leave you with this chart of Ford, one of my favorite stocks to use for covered calls. A Dec $14.50 call returned just over 2.5% in December and left the stock in my possession. At the end of the month a Jan $14.50 call was providing similar return, except less than expected December auto sales caused a decline in the entire sector that would have wiped out all profits and more.