Layered Covered Call Income Cycle — Strategy Spec

Strategy ID: lcc-income-cycle Status: Research / Pre-backtest Date: 2026-05-05 Analyst: Data-scientist agent (Raxx) Source Brief: Kristerpher's "Covered Call Income Cycle" brief, 2026-05-04

1. Plain-English Summary

The Layered Covered Call Income Cycle (LCC) sells short-dated (typically weekly) covered calls against an owned share position using a multi-strike distribution rather than a single ITM strike. The distribution varies by the trader's pre-committed sentiment label (Neutral / Bullish / Bearish / High-Uncertainty). The system tracks premium income, realized P/L from assignment, tax-lot accounting, and re-entry decisions as explicit state transitions — not discretionary judgments made under pressure.

This is a paper-trading simulation first. No live broker calls are part of this specification.

2. Hypothesis

Primary: A layered strike distribution (1-2 ITM + 1-2 ATM/OTM + optional uncovered shares) produces higher net cycle P/L per week than a single full-ITM covered call structure, primarily by preserving some upside participation and reducing the frequency of below-cost assignment.

Secondary: Pre-committed sentiment labeling (applied before market open) outperforms reactive strike selection at open, because it removes intra-day anchoring bias from the execution path.

What "better" means in this context: Net cycle P/L = premium collected + assignment proceeds + unrealized equity change, compared against a baseline of (a) buy-and-hold, (b) single-strike full-ITM covered call, and (c) selling no calls at all.

Neither hypothesis constitutes a prediction. Both are empirically testable on historical paper-trade data after simulation is instrumented.

3. Universe and Scope

4. State Machine — Position Lifecycle

States and legal transitions:

NO_POSITION
  → [buy shares] → LONG_SHARES

LONG_SHARES
  → [sell calls] → CC_ACTIVE
  → [no calls sold] → LONG_SHARES (hold)

CC_ACTIVE
  → [DTE > 2] → CC_ACTIVE (monitor/roll)
  → [DTE ≤ 2] → NEAR_EXPIRATION

NEAR_EXPIRATION
  → [all calls OTM at exp] → LONG_SHARES (calls expire worthless, keep premium)
  → [≥1 call ITM at exp] → ASSIGNED (partial or full)
  → [manual buy-back before exp] → LONG_SHARES or CC_ACTIVE

ASSIGNED
  → [re-entry criteria met] → LONG_SHARES (re-buy shares, restart cycle)
  → [re-entry criteria not met] → NO_POSITION (wait)

NO_POSITION
  → [re-entry criteria met] → LONG_SHARES

Each transition records: timestamp, price, lot affected, P/L contribution, reason code.

5. Sentiment Label — Pre-Committed Before Open

Sentiment is assigned the night before or pre-market. Once committed, it governs the day's call structure. It cannot be changed intra-day except by a manual override with a logged reason.

Sentiment label is the trader's pre-committed input — not a model output. The system enforces whatever structure corresponds to the label. The AI layer may surface historical context (prior weeks at similar price/IV, prior assignment outcomes) but does not override the label.

6. Strike Selection Rules

Delta is measured at time of entry (post open, after price-action check per Section 7). Targets are approximations; nearest tradeable strike within ±$2.50 is acceptable if delta constraint is met.

7. Opening Bell Execution Rule

The system does not fire sells at market open. Price-action check runs 10 minutes after open:

"Gap" is defined as (open – prior close) / prior close. Thresholds are configurable. The system logs the condition at T+10 and the resulting action for every cycle.

8. Exit / Roll Decision Tree

This tree is pre-committed. The system flags when a condition is met; the trader confirms (Phase 1–2) or the rule executes automatically (Phase 3+, paper only).

Premium remaining > 85% of original credit?
  No → hold
  Yes → buy back (lock profit)

Stock dropped significantly after sell?
  Extrinsic value < $0.10?
    Yes → buy back (cheap); recapture upside
    No → hold

Stock surged; short call now deep ITM?
  Net credit available to roll up/out?
    Yes → roll up (same expiration) or roll out (next week, same/higher strike)
    No → evaluate: let assignment happen, or pay debit to close

Assignment acceptable at this strike?
  Strike >= cost basis of lot being assigned?
    Yes → let assignment happen; log as "intentional exit"
    No → evaluate roll or close; log as "below-cost assignment risk"

DTE = 0 (expiration day) and call is ITM?
  → Assignment expected; prepare lot selection and re-entry criteria check

9. Assignment Handling

1. Remove 100 shares per assigned contract from position, applying the configured tax-lot method (LIFO default).
2. Record: assignment price, lot cost basis, assignment P/L = assignment price − lot cost basis.
3. Add premium already collected to premium_collected ledger (premium was booked at sale, this step finalizes the cycle entry).
4. Evaluate re-entry criteria (Section 10).
5. Rebuild call layer on remaining shares if any remain.

Assignment is a designed outcome, not a failure. The system never marks assignment as a loss event automatically — the P/L calculation determines outcome.

10. Re-entry Criteria (All Must Pass)

If any criterion fails, state remains NO_POSITION and the system logs which criterion blocked re-entry.

11. Risk Controls (Formalized)

12. Edge Cases Not Covered in the Original Brief

These require confirmation from Kristerpher before implementation:

EC-1: Early assignment (American-style) AMZN options are American-style. Early assignment can occur when extrinsic value approaches zero (typically for deep ITM calls near ex-dividend). The system must check daily whether any short call has extrinsic ≤ $0.05 and flag early assignment risk. The brief does not specify handling — recommend treating as identical to standard assignment (Section 9) and logging the "early" flag.

EC-2: Dividend-driven early assignment If AMZN reinstates a dividend (currently none), holders of short calls with strike below ex-div price may be assigned the night before ex-div. The system should block new ITM call sells within 5 days of any future ex-div date for dividend-paying tickers in the universe. No current risk for AMZN but architecture must support it.

EC-3: Trading halt during expiration If the underlying halts on expiration Friday, OCC standard procedure is to extend the expiration window. The system should not auto-act on expiration day until after 4:00 PM ET confirmation. Paper-trading state machine holds at NEAR_EXPIRATION until confirmed.

EC-4: IV crush post-event If IV collapses after a catalyst (e.g., broad market spike, FOMC), extrinsic on open calls evaporates. The system should detect when a held call's extrinsic drops >50% intra-day and alert: "IV crush — consider closing for residual credit."

EC-5: Assignment on fractional cycle Brief assumes 100-share lot multiples. If re-entry results in a share count not divisible by 100 (e.g., 470 shares), the system must track the "uncovered" remainder and not flag it as a naked call.

EC-6: Roll creates net debit The brief says "roll up if net credit or acceptable debit." The system needs a configurable max-debit threshold (suggested: $0.25/share) above which a roll is blocked and the situation escalates to manual review.

13. Data Requirements

See data-schema.md in this strategy directory for the full schema. Summary of required inputs:

14. Assumptions Requiring Explicit Acknowledgment

These assumptions are embedded in the reference implementation. They are not predictions — they are modeling choices that affect backtest validity:

1. Fill at mid: Paper fills modeled at bid/ask midpoint. Real slippage may be $0.02–$0.05 worse per contract depending on spread and time of day.
2. No partial fills: The simulation assumes full-lot fills. Real execution on illiquid strikes may see partial fills.
3. Assignment at 4:00 PM ET strike price: OCC exercise is based on intrinsic value at 4:00 PM ET close. After-hours moves can create unexpected assignment/non-assignment; paper sim uses 4:00 PM price.
4. Commission: $0.65/contract (Alpaca default as of 2026). Configurable in backtest config.
5. Tax treatment: P/L tracking is gross of tax. The tax-lot method simulation tells you which lots are assigned but does not calculate capital gains tax owed. A CPA, not this system, handles tax.
6. LIFO paper default: LIFO is the default lot method in the simulation. Actual broker LIFO eligibility may differ; paper sim is illustrative.
7. Delta at entry: Delta is snapshot at the moment of sell execution. Delta drifts continuously; the system does not delta-hedge.

15. Open Questions for Kristerpher

See failure-modes.md for full list. Top three:

1. What is the maximum acceptable debit on a roll? The brief says "acceptable debit" but does not define a dollar or percentage threshold. This gates the roll decision tree in Section 8.
2. Is early assignment to be treated identically to standard assignment for P/L and re-entry logic, or does it trigger a different workflow? AMZN is American-style; this will occur.
3. When sentiment is "High-Uncertainty," the brief allocates 100 uncovered shares. Does "uncovered" mean no call is sold against those shares for that cycle, or does it mean a far-OTM (delta <0.15) call is acceptable as a hedge-write?

16. Cited References

• CBOE. "Covered Call Writing." CBOE Strategies, 2024. (non-peer-reviewed; practitioner reference)
• Israelov, R. & Klein, M. "Covered Calls Uncovered." Financial Analysts Journal, 2016. SSRN 2670759. (peer-reviewed)
• Coval, J. & Shumway, T. "Expected Option Returns." Journal of Finance, 2001. (peer-reviewed; establishes that selling options has positive expected P/L net of risk)
• Leland, H. "Who Should Buy Portfolio Insurance?" Journal of Finance, 1980. (foundational on option writing as insurance analogy)
• Alpaca Markets. "Options Trading API Documentation." 2025. (practitioner; broker-specific)
• ORATS. "Historical Volatility and Options Data." orats.com, 2025. (industry; subscription required for historical)
• tastytrade Research. "Covered Calls: What the Research Says." research.tastytrade.com, 2024. (practitioner; not peer-reviewed; flag accordingly)

This document is a research specification. It does not constitute investment advice. Performance in any tested period depends on conditions that will not be replicated. Paper-trading results do not guarantee live-trading outcomes.