Wed Feb 15, 2006: Rambus (NASDAQ-RMBS) Smoothing Covered Call Income

Rambus stock closed at 28.25 today.

March 30.00 calls were last bid at 2.30 and May 30.00 calls were last bid at 5.10.

Which are better to sell, the one-month March 30's or the three-month May 30's?

How about both?

If you're interested in earning income from selling covered calls, the first task is to find a stock that you're comfortable with owning in terms of the downside price risk as well as the option yield.

Next is selecting which covered call to write -- at the money, in the money, out of the money. The tables on this site can help with that part, plus another part that is often overlooked: which month? or months!

Many people focus on the current month's options because they know that since the rate of time decay increases as you get closer to expiration, the shorter-term options provide the highest income per month.

Typically they plan to sell one-month at the money covered call options month after month until they are called away, hoping that the underlying stock they've purchased either goes up or stays relatively flat while they're waiting for the option to expire.

A problem arises if the stock goes down sharply the first month. The first round of calls sold do expire worthless, but now the income yield available for the next month calls is very low. As discussed in a recent commentary on covered put writing, one approach at this point is to sell a two-month or three-month option at the original strike price to make it worthwhile.

But I'd like to suggest another approach here that you might find useful, which is to plan ahead for the possible dip in the stock price and sell some one-month and some multi-month right from the beginning. You can continue this each month, so that when this month's calls expire some further-out month's have already been sold, and you focus on selling another multi-month option at that point.

This can smooth out your monthly option income right from the start, giving you a little more peace of mind that if the stock drops the first month you at least got a little more income up front.

Let's briefly look at the RMBS example. Right now there are no two-month April calls available for trading (there will be starting next Monday). The yield on March 30's is 8.9% for one-month. The yield on May 30's is 22.0% for three months, or about 7.3% per month.

Now right away some investors might choose to keep it simple and just write all May's, figuring that locking in 7.3% per month for three months in a row is almost as good as 8.9% and also "safer".

It is simpler, but let me suggest that over the long run, you'll do better by spreading out your covered call months to smooth out your returns while also providing more opportunities to lock in high gains and less chance of having to accept low ones.

Think ahead. If the price of RMBS stays flat for a month or two but then drops sharply before the May expiration, you won't be able to get much for selling your next round of calls at that point.

But if you sell some March's and some May's now, then when the March's expire you'll be able to sell August's ahead of time, without having to wait for the May's to expire. Or you could sell April's then.

Ideally we'd like the stock to be at 29.99 when the current month's options expire. That would provide the maximum at-the-money yield for the next months. Sometimes we'll get that lucky, but chances are that won't happen every time!

By spreading out our covered call months, we'll have more flexibility because we'll have options expiring at different times.

One more idea is to be patient after option expiration day and not immediately sell a new round of calls the following Monday if the stock is down. If you do, you might be disappointed when the stock suddenly shoots back up within a couple days. Then you could spend the rest of the option month kicking yourself for accepting such a low premium when you could have done much better by waiting a couple days. If you are comfortable owning the stock even without the option income, this patience should come easily. If not, you have picked a stock that is too risky for you, as some investors recently found out with RHEO.

By the way, RMBS is not exactly the most stable stock around either.

But whichever stock we choose, rarely will it finish right where we want it to on expiration day (or open for trading where we want it to the following Monday). Often it makes its peak for the option month sometime in the middle, and this is the best time to sell your next round of calls.

Don't let this disappoint you. Accept these fluctations as part of the market. And plan ahead for them.

By spreading your calls over two or more months, you can smooth your income and you might find your covered call option writing experience less frustrating, and more profitable.

Best of luck with your option investments!