Rules for Broker Behavior with Covered Calls

Question

When selling covered calls, there are a couple of things a broker could do if the stock has a sharp increase. Here's an example:

Buy Stock: $100
Sell Call $120@1month: $1

Two days later, the stock spikes up to $120 and my call now costs $22. The broker can do two things:

Plan #1:  Wait for someone to execute the calls on the stock you already own.
+$1: Sell the call
+$0: Exercise the call.
---
$1: Profit

Plan #2:  Buy the call at the current price to cover.
-$22:  Buy the long call
+$20:  Difference in stock price
+ $1:  Sell the short call
---
-$1: Loss

I think that I would want #1, but what if the broker forces #2. I think this is a question of acceptable margin. However, there really is no risk to the broker since I already own the stock. How can I be sure they don't do #2 on me?

Answer 1

Number 2 cannot occur. You can buy the call back and sell the stock, but the broker won't force that #2 choice. To trade options, you must have a margin account. No matter how high the stock goes, once "in the money" the option isn't going to rise faster, so your margin % is not an issue. And your example is a bit troublesome to me. Why would a $120 strike call spike to $22 with only a month left? You've made the full $20 on the stock rise and given up any gain after that. That's all. The call owner may exercise at any time.

Edit: @jaydles is right, there are circumstances where an option price can increase faster than the stock price. Options pricing generally follows the Black-Scholes model. Since the OP gave us the current stock price, option strike price, and time to expiration, and we know the risk free rate is <1%, you can use the calculator to change volatility. The number two scenario won't occur, however, because a covered call has no risk to the broker, they won't force you to buy the option back, and the option buyer has no motive to exercise it as the entire option value is time premium.

Answer 2

I think the question, as worded, has some incorrect assumptions built into it, but let me try to hit the key answers that I think might help:

Your broker can't really do anything here. Your broker doesn't own the calls you sold, and can't elect to exercise someone else's calls.

Your broker can take action to liquidate positions when you are in margin calls, but the scenario you describe wouldn't generate them: If you are long stock, and short calls, the calls are covered, and have no margin requirement. The stock is the only collateral you need, and you can have the position on in a cash (non-margin) account. So, assuming you haven't bought other things on margin that have gone south and are generating calls, your broker has no right to do anything to you.

If you're wondering about the "other guy", meaning the person who is long the calls that you are short, they are the one who can impact you, by exercising their right to buy the stock from you. In that scenario, you make $21, your maximum possible return (since you bought the stock at $100, collected $1 premium, and sold it for $120. But they usually won't do that before expiration, and they pretty definitely won't here. The reason they usually won't is that most options trade above their intrinsic value (the amount that they're in the money).

In your example, the options aren't in the money at all. The stock is trading at 120, and the option gives the owner the right to buy at 120.* Put another way, exercising the option lets the owner buy the stock for the exact same price anyone with no options can in the market. So, if the call has any value whatsoever, exercising it is irrational; the owner would be better off selling the call and buying the stock in the market.