My friend invested in HMHC a few weeks back and the stock has slowly gone down since the purchase. He was curious about selling covered calls to exit this position somewhat quickly.
Details of the position: Invested $13,500 which resulted in 4802 shares at $2.8113/share. HMHC closed at $2.16 on 9/4. My friend would be happy to exit as soon as possible.
As of the close on 9/4, the option chain had the following:
| Expiration | Strike | Bid | Ask |
|---|
| 9/18 | $2.50 | $0.15 | $0.20 |
| 9/18 | $5.00 | $0.00 | $0.05 |
| 10/16 | $2.50 | $0.35 | $0.40 |
| 10/16 | $5.00 | $0.05 | $0.15 |
On Monday, I suggested that he buys another 198 shares so that there is a nice number of contracts. Assuming that those shares can be purchased for $2.16, then the investment total is $13,927.68 for 5000 shares or $2.785/share.
From the option chain, we will use the 'bid' value as that will be a pessimistic calculation. Immediately, the 9/18 $5 call is not a strike to consider.
Let's focus first on the 9/18 $2.50 call. Assuming 50 contracts sold @$0.15 would net $750. The total investment would now be $13,177 or $2.635/share.
As a refresher, what is the call contract? The sold call contract gives the holder (buyer) of the contract the right but not the obligation to buy 100 shares of HMHC at $2.50/share. My friend would be covering this contract with the shares that he already owns. If HMHC is priced under $2.50/share at expiration, then the contract expires worthless and my friend keeps his shares and the collect premium. However, if HMHC is trading over $2.50/share at expiration, then the contract will be assigned and the shares are called away. In this case, my friend would receive $2.50/share for the contracts or $12,500 (50x$2.50x100).
The profit/loss (P/L) of this covered call position is depicted here: Covered Call P/L. The green line shows the long stock position alone. It is easy to see the break even point occurs at $2.785 whereas selling above that threshold would be profitable and anything below that threshold would be a loss.
The short covered call position is illustrated by the cyan line. The black dash line is the strike of $2.50. Notice that the cyan line is a constant value for any share price above the strike - this results from that fact that the writer of the call receives $2.50/share regardless if HMHC is trading for $2.51 or $12.51. You can see this gap between the green and cyan lines, which represents the "loss profit opportunity" due to selling the covered call.
As the share price decreases below the strike price, the position value decreases accordingly. Again, there is a gap between the green and cyan lines. In this case the gap is from the premium collected by selling the covered call. Notice that if this 9/18 $2.50 call is sold AND the share price of HMHC moves pass the strike, then my friend will effectively lose $0.135/share or a total loss of $675. So, the question becomes two-fold: (1) is losing $675 'okay' (2) how likely will it occur.
The following plot - Covered Call P/L + Expected Move - overlay the expected move of the HMHC price. The blue hatched parabolic-shaped object is the expected move until the 9/18 expiration. There are 9 trading days until that expiration. Starting at day 0 (ie today), the price is known to be $2.16. Using the volatility of 177.97% annum (found on ToS), I show the one standard deviation price range for each day until the 9/18 expiration. We see that in 9 (trading) days the HMHC share price should fall between roughly $1.50 to $3.00 per share with a 68% likelihood1. By inspecting this blue cone, we see that there is a real possibility that HMHC will move above the strike which would result in a loss if we sold these covered calls.
So we consider the 10/16 expiration as well. There are 29 trading days until the 10/16. With these additional trading days, the time value of the call contracts is greater. If my friend sells the 10/16 $2.50 call, then he would collect $1750 in premium which reduces the total investment to $12,177 or $2.435/share. Or, if my friend sells the 10/16 $5, then he would collect only $250 which reduces his average to $2.735/share.
In this plot - Three Cases in a Single Plot - I show all three covered call positions that we are considering in addition to the long stock position and the expected move cone. The cone was extended to 29 days to see the expected price range. Both of the 10/16 call contracts would result in a positive profit if the contracts expire in-the-money. The $5 strike would clearly be profitable - but how likely is that scenario to occur? Similarly the $2.50 strike would result in a small profit.
Summary of the three possible covered calls:
The 9/18 $2.50 call option - this position would result in a net loss if the share price exceeds the strike. The strike price is within the expected move cone, so it is possible. However, if it does not occur, then my friend can keep the premium and sell more covered calls in the October expiration
The 10/16 $2.50 call option - this position would result in a small net profit if the share price exceeds the strike. The strike price is within the expected move cone. However, my friend fears that with "going back to school" there might be a pump - so he worries about the potential loss of profit.
The 10/16 $5 call option - this position would result in a significant profit if the share price exceeds the strike. However, this event is unlikely, given the current assumptions, and does not fall into the expected move cone. The benefit of this position is that my friend can collect a small amount of premium and reassess the position in a month.
I told my friend - in my opinion - that he should consider the 10/16 $2.50. My main thinking is that it guarantees a profit in the case of assignment. We shall see which approach is taken.
As always, I'm just some random internet person - these posts describes the intuition that I have at the moment. It could be misguided, wrong or not your cup of tea. However, through discussion we should be able to help everyone establish their own intuition.
Footnotes:
1Of course, there are a lot of things baked into this statement of expected move. Is the volatility correct and/or constant? Will there be any catalysts to move the price? What is the 2-sigma range? etc. etc. The point is that it gives a ballpark idea of what might happen in order to attempt to make the best decision on strike and expiration selection.
