What is assignment?
If you sell a covered call, you’re accepting an obligation in exchange for the option premium you collect. Your underlying shares of stock might be “called” away from you if the option buyer chooses to exercise. We say “might” here because it’s not guaranteed that you’ll be asked to honor this obligation. It depends on whether you get assigned. Here’s how the assignment process works.
Assignment happens via a random lottery system run by the Options Clearing Corporation (OCC). When the OCC receives an exercise notice, it’s assigned randomly to a member clearing firm. In turn, your brokerage firm randomly assigns exercise notices to short options positions on their books. It’s possible you’ll be assigned through this process.
Of course, it’s also possible you’ll skip out scot-free. But if the call option you’ve sold is more than a few cents in-the-money at the expiration date, the chance of escaping assignment is highly unlikely. In addition, even though exercise usually depends upon whether the option is in- or out-of-the-money, an option buyer can choose to exercise his or her option at any time until expiration, for any reason, whether it makes sense or not. As you’re probably aware, human beings don’t always behave in a rational manner.
What are the risks in covered call writing?
Although covered call writing is generally considered a fairly conservative option strategy, there are risks. Remember, as a covered call writer you’re wearing two hats: You’re a call seller and you’re also a stockholder.
Downside risk as a stockholder. If the value of your underlying shares falls significantly, the loss from holding the stock will likely outweigh the gain from the option premium received.
Limited upside as a stockholder. Before selling a covered call, as a stockholder you have unlimited potential upside
from owning the stock. When you start writing covered calls, your potential gain from owning the stock is limited to the gain you may realize if the share price reaches the strike price of the option. At some point after this occurs, the shares will likely be “called away” and you will sell the shares for the strike price.
Tip 1: Keep volatility (likelihood of stock price movement) in mind.
Writing covered calls works best on stocks with options that are exhibiting medium implied volatility. This means you want to use a stock that has the ability to move, but in a somewhat predictable way. If implied volatility is too low, the option premium you collect will also likely be low. If implied volatility is high, the premiums will also be higher, but there is a trade-off.
The higher the implied volatility, the greater the likelihood for the stock to move significantly in either direction. This could mean you have a higher chance of having your stock called away if the price increases, or of taking a loss if the stock drops sharply. Remember: If the price rises enough that the call buyer exercises the option and calls your stock position away from you, you’ll no longer be a stockholder _ precluding you from participating in future gains in the stock beyond the strike price.
In other words, medium volatility should provide enough premium to make the trade worthwhile, while reducing the amount of unpredictability found with high-volatility stocks. Only you can decide what kind of option premium will make this strategy worth executing.