How Many Shares Are Needed to Sell Covered Calls?
As an SEO optimised article for Google, this piece explores the question of whether owning fewer than the standard 100 shares is permissible when selling covered calls. This guide aims to demystify the mechanics of covered calls, address common misconceptions, and provide clarity on related nuances.
Understanding Covered Calls
Before delving into the specifics, let's clarify what covered calls are. A covered call is an investment strategy where the investor owns 100 shares (or an equivalent fraction) of a stock and sells a call option on that same stock. The aim is to earn extra income from the premium received for selling the call while protecting against a decline in the stock price. However, this strategy comes with the obligation to sell the underlying shares at the strike price if the option is exercised.
Minimum Share Requirement for Selling Covered Calls
Contrary to popular belief, owning fewer than 100 shares does not immediately disqualify one from selling covered calls. The key issue lies in the idea of delta neutral trading strategies.
Owning 20 Shares
If you only own 20 shares of a stock, you cannot sell a single covered call on that stock. This is because selling a call option obligates you to sell 100 shares if the option is exercised. Thus, owning only 20 shares leaves you short of 80 shares, which would be required to fulfill the obligation. Consequently, this trade would be considered naked, as your position is not adequately covered.
Cash Accounts and IRA Accounts
The situation becomes somewhat more flexible when trading from a cash account or an IRA account. In these cases, even if you do not own 100 shares, you can still sell covered calls under certain conditions.
For instance, if you have a cash account, you can effectively cover the position with cash, rather than physical shares. Alternatively, with an IRA account, option trading is generally allowed under specific conditions.
Margin Accounts and Non-Retirement Accounts
However, the rules become clearer in non-retirement accounts with margin capabilities. If you meet the criteria for the highest level of options trading in a margin account, you can sell covered calls without owning the underlying shares. This is a sophisticated strategy and should be considered only after thorough understanding and risk assessment.
Delta Neutral Strategies
A delta neutral strategy allows traders to maintain a position that is not sensitive to small changes in the underlying stock price. This can be achieved by owning enough shares to offset the effect of the sold call option.
Example
Consider a scenario where a stock is priced at $62.50, and the 65 calls have a delta of 0.50. To achieve a delta neutral position, a trader might buy 50 shares and sell one call option. While the position is delta neutral, it is not covered, as the requirement for 100 shares would still apply if the position is to be fully covered.
Therefore, a covered call is only truly covered if the trader already owns the underlying 100 shares, whereas a delta neutral strategy involves a more nuanced approach.
Unusual Conditions in Stock Splits
Another interesting aspect to consider is the impact of stock splits on covered call strategies. For example, if a stock initially priced at $50 splits 3:2, you would end up owning 150 shares priced at $33.33, and your call at $47.50 would become a 31.7 call. After the split, you would still need to own 100 shares to sell a new call, aligning with the standard requirement.
Conclusion
To sum up, owning fewer than 100 shares does not inherently prevent you from engaging in covered call strategies, but it depends on several factors such as account type, margin usage, and specific trading conditions. Whether you own 20 shares, have a cash/IRA account, or use a margin account, the core requirement of owning 100 shares for a fully covered position remains fundamental.
Traders should familiarize themselves with these nuances to make informed decisions in their option trading strategies.