Harvesting Premium By Shorting Out-of-the-money Calls

Have you ever been in the fortunate position of holding a stock that had rallied a long way, but you were concerned it had gone too far too fast, yet you did not want to sell your position?

Or, have you ever thought that the market would go sideways for a while, and you did not expect your stocks to rally? Maybe you have seen this during the slower summer months.

If you are in either of these situations, then a good strategy might be to harvest premium by shorting out-of-the-money calls.

Let us begin with the first scenario, where you own a stock that has appreciated in value, but you anticipate a pullback in the near future. One stock that might fit these criteria is Shopify.

Chart 1: Daily chart of Shopify (symbol SHOP) 2018–2020

 Source: Bloomberg

Since the March lows caused by the coronavirus crisis, SHOP has rallied from approximately $400 to $1,400 before pulling back to $1,261.35.

If you believed that SHOP was about to correct even further in the coming month, then selling an out-of-the-money call might be a good strategy to improve your cost base.

For example, on July 20, 2020, an investor was able to sell an August 21, 2020, call with a strike price of $1,350 for $67.40.

Since you own the stock, your calls would be covered and not require any more margin. If SHOP were to correct over the next month as you thought, then the calls you sold short would expire worthless and you would improve your cost base by 5.34% for a month’s work. If SHOP were to rally, it would have to break out to new highs before the position would become a loss:

Strike price of $1,350 + Premium earned of $67.40 = $1,417.40 breakeven level

Another situation that may well be suited to premium harvesting through out-of-the-money call selling is when you are expecting the market to enter a slow period.

Often the summer months become less volatile, with less market movement. In this scenario, an investor may benefit from selling out-of-the-money calls on existing stock positions.

Let us say that you have a position in Royal Bank, and believe that its share price will be relatively stable over the next month.

Chart 2: Daily chart of Royal Bank of Canada (Symbol RY) 2018–2020

 Source: Bloomberg

Back on July 20, 2020, an investor could have sold calls on RY that expire on August 21, 2020, for $1.50 per share. Royal Bank goes ex-dividend on July 24, 2020, in the amount of $1.08, so, if in a month’s time share price of Royal Bank is unchanged, you would have earned the following:

RY CALL August 21, 2020, premium earned $1.50 + Dividend $1.08 = $2.58 per share

That equals a return of 2.69% per share.

Investors sometimes believe that they need to sell their shares when they have “run too far too fast” or are about to enter a “quiet period”. This is not necessarily true. Often there are opportunities to short calls against their long holding as a way to earn a premium and improve the cost base of their shares. Harvesting that premium is a good alternative strategy that all investors should consider having into their toolkit.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.