Selling call options at resistance

As we can see from the following chart, the share price of Canada Goose Holdings Inc. (GOOS) just hit the $90 resistance level after a major 50% rally in just one month. We can also see that the RSI (5) has fallen, while the stochastic indicator shows it is in overbought territory (%K [89]). This situation is an indication of a temporary halt in the stock’s rise, or even a more or less pronounced decline.

Daily graph as at November 26, 2018 ($87.98)

An investor who wants to profit from time decay during this lull, while also gaining useful protection, could sell a call option for each slice of 100 stocks held. With the stock price at $87.98, we will calculate the value of three call options expiring on January 18, 2019 with strike prices of $86, $88 and $90.

Comparison of profit and loss profiles

The table above compares the profit and loss profiles for a strategy that sells covered calls based on different strike prices; $86, $88 and $90.

Call options with a strike price of $86 allow to collect a premium of $8.15 per share, or $815 per contract. This in-the-money option, which has an intrinsic value of $1.98 ($87.98 – $86) and a time value of $6.17 ($8.15 – $1.98), provides a protection of 9.26%  against a stock price decline. The maximum profit of $6.17 per share (strike price of $88 – stock price of $87.98 + premium received of $8.15) or 7.73% (53.23% annualized) will be achieved if the stock price is higher than the strike price of $88 when the option expires on January 18. The static profit, i.e., the profit generated if the stock price holds steady until expiry, is the same as the maximum profit.

Call options with a strike price of $88 allow to collect a premium of $7.50 per share, or $750 per contract. This at-the-money (actually, slightly out-of-the-money) call option, which has no intrinsic value and a time value of $7.50, provides a protection of 8.52% against a stock price decline. The maximum profit of $7.52 per share (strike price of $88 – stock price of $87.98 + premium received of $7.50) or 9.34% (64.35% annualized) will be achieved if the stock price is higher than the strike price of $88 when the option expires on January 18. The static profit, i.e., the profit generated if the stock price holds steady until expiry, is $7.50 per share (the time value of the call options) and represents a return of 9.32% (64.18% annualized).

Call options with a strike price of $90 allow to collect a premium of $6.40 per share, or $640 per contract. This out-of-the-money call option, which has no intrinsic value and a time value of $6.40, provides a protection of 7.27% against a stock price decline. The maximum profit of $8.42 per share (strike price of $90 – stock price of $87.98 + premium received of $6.40) or 10.32% (71.08% annualized) will be achieved if the stock price is higher than the strike price of $90 when the option expires on January 18. The static profit, i.e., the profit generated if the stock price holds steady until expiry, is $6.40 per share (the time value of the call options) and represents a return of 7.85% (54.03% annualized).

When choosing the strike price, the investor must make a trade-off between the maximum return and protection in the event of a decline.

Intervention

If the stock price falls or remains stable, action may be taken if we can purchase call options sold for between 10% and 20% of the initial price. In such a case, we should conduct an analysis to confirm whether it is still a good idea to keep selling call options to hedge against risk. If the price rises higher than the strike price, the call options will have to be re-purchased at a profit or a loss, depending on the situation, to prevent them from being assigned and having to sell the underlying stocks. If not, the call options will be exercised by the holder and we will be forced to sell the stocks at the chosen strike price.

Good luck with your trading, and have a good week!

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.