Friday, April 16, 2010

Covered Calls and the Oracle of Omaha

Let's pop open the mailbag and tackle some viewer mail.

I bought 100 shares of BRK-B at $71 shortly after it split. I've been thinking about covered calls on the stock. I plan to hold it for several months and figured maybe I could sell the calls in the meantime. I expect the stock to stay pretty flat for a while, so doesn't it make a good candidate? Karen-
Hey Karen,

Evaluating covered call candidates is a two part process. Since they perform best in neutral to mildly bullish markets, I would first find a stock that fit that description. However, not all stagnant to mildly bullish trending stocks are going to work for covered calls. The second part of the process involves assessing the options chain to determine if there is a strike price that will provide sufficient premium to make the trade worthwhile. There are a couple problems that may crop up when trying to find the right option to sell. First, the strikes may be too far apart, which means you'll either have to sell a call option that is ITM (which cuts off any appreciation in the stock price) or one that is too far OTM (which may offer little premium).

The second issue that may arise is that of volatility. If the implied volatility of the options you're considering selling is too low, there may not be enough premium to make it worth your while. With this process in mind, let's take a stab at BRK-B (click to enlarge).
[Source: MachTrader]

You'll have to be the judge on whether or not the chart is neutral to mildly bullish. I'd say it looks more neutral, though it has rolled over a bit in the last month. Take note of the historical volatility displayed at the bottom of the chart. At 9%, BRK-B is definitely not a mover and a shaker (the post split ramp being the exception of course). As a result the options trade at pretty low implied volatility levels and therefore offer little premium when compared to the $80 you're shelling out to buy shares of stock.

One final issue worth mentioning is the availability of strikes. Due to its high share price, BRK.B only offers strikes every $5 apart. Given its low volatility a $5 move is quite large. Consequently, the OTM options don't offer much premium at all. In the May expiration cycle, the only strike in play is the 80 and it's only offering $1.50. The 85 strike is too far OTM and the 75 is too far ITM.

For related posts, readers are encouraged to check out:
Investigation of an Over-Write
Over-Writes: A Delta Perspective
Over-Writes: A Delta Perspective Take Two

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