Hi Mark
Please explain the risk of getting a call from my broker under this scenario. I am in Canada.
Today I bought 10 RIM C JUN 130 for $20.55. TOTAL COST = $20,550.00
I sold 10 RIM C DEC 125.00. I got income of $6.35 per contract. So my account got a credit of $6350(-brokrer fee.)
Q) What happens if RIM goes to $135 say in 2 weeeks or in 2 days?
What happens to my account and how can I use my RIM LEAP to cover my DEC CALL?
A detail step by step explanation will be highly appreciated.
Thanks
Nirmal
Nirmal,
Let me begin by telling you that you DO NOT OWN A COVERED CALL POSITION. Regardless of what Terry (or someone else) told you, this is not a covered call. It is a position that is far more risky when the market rallies, but is better when the market declines.
1) You paid $20,550 and collected $6,350. Your total cost for these transactions is more than $14,000.
2) When you collected $6,350, I don't think it's right to call it 'income.' It's potential income, but unlike a covered call position, this type of spread can lose a lot of money if the stock rises too quickly.
3) If RIMM moves to $135 today, you quickly become short deltas. That means you can expect the option you sold to increase in value more quickly than the option you own. Simply put, that means you lose money as the stock continues to rise.
4) If RIMM moves towards $135 as expiration nears, the same is true. Although you can expect NOT to receive an exercise notice before expiration arrives (it's possible, but unlikely), if the option is in the money at the close of business on expiration Friday, you will be assigned an exercise notice (and hear that from your broker). That requires that you sell 1,000 shares short. It's a high priced stock and the margin requirement is pretty steep. Although you are allowed to carry short stock, I doubt that you want to do so because you clearly intend to own a bullish position on RIMM.
5) If your account is NOT allowed to carry a short stock position, you may hear from your broker earlier - with a warning to buy in your short option. That's done to prevent you from remaining short the December call and eventually being assigned.
6) To prevent being assigned an exercise notice,you can repurchase those December calls and write (sell) a different call against your long June calls. But that entails the same risk if RIMM heads through the strike price of the option you sell.
7) About LEAPS (NOT LEAP, it's always LEAPS). You do NOT own LEAPS calls. LEAPS options always expire in January and always have at least 9 months of lifetime remaining. When it dips under 9 months, the LEAPS options are transformed into a 'regular' January option. In any case, your June calls are not, nor have they ever been, LEAPS.
8)You can use your Jun calls (or LEAPS, if you owned them) to cover your Dec call by doing something stupid - exercising them. BE ABSOLUTELY CERTAIN YOU DO NOT EXERCISE. BE ABSOLUTELY CERTAIN THAT YOUR BROKER WILL NOT EXERCISE THEM IF YOU RECEIVE AN ASSIGNMENT NOTICE ON YOUR DECEMBER CALLS. There are two things you can do: The first is to buy in the Dec calls, as mentioned above. But, if I were you, I'd call my broker and ask what they do if you do receive that assignment notice. Be certain they will not exercise your long calls for you. Some irresponsible brokers do that and you must be certain yours promises not to do that. If they will not promise, you had better close this position sooner, rather than later and change brokers.
9) There is always the possibility that this position will turn out well, but the strategy you are using is much more risky than writing covered calls when the markets are rising. I'm not suggesting that you write covered calls. What I am doing is telling you that buying LEAPS and selling near-term calls is not the easy path to riches that those who tout it claim it to be. It's risky when stocks rally.
10) Technically, your long calls always cover your short calls - even if you are assigned an exercise notice. But once assigned the position becomes bearish, not bullish. And one important point: You cannot carry short stock if you cannot meet the margin requirement. Nor can you carry short stock in any type of retirement account. If you plan to own short stock, you must have approval from your broker. So ask for that approval, just in case you are assigned.
Good luck,
Mark
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