Covered Calls

 

The primary objective of the covered call writer is increased income through stock ownership.  Coupled with that is the desire to minimize inherent risks of the market. There are various strategies for covered call writers.  Some strategies could satisfy the most conservative investor while others would challenge the most aggressive.  We offer this tutorial to teach some of the strategies that are relatively unknown by the vast number of covered call writers.  We do not contend that this is an all-inclusive authority on the subject, but a brief tutorial only.   All covered calls involve selling an option on a stock that you currently own.  But there are two broad terms that "categorize" your position: In-The-Money and Out-Of-The-Money.  If you own a stock that is trading at 19 and sell the 20 call, then the option is deemed "out of the money".  There is no intrinsic value in the option.  The only value it has is time value.  If you sold a 15 call on the 19 stock that you own, then the option is said to be "in the money".  It is in the money by 4 dollars.   The option of course would be worth more than 4, depending on the amount of time left before expiration. Typically, writing a covered call by selling an out-of-the-money option offers the highest returns, while writing a covered call with in-the-money strikes offer the highest degree of safety.  The deeper in the money the safer.  There are also combination strategies to maintain a high degree of safety, and obtain higher yields as well.

Out of the Money Example: ABC stock is selling for 22 1/2 and the January 25 call is selling for 1. If you were to buy the stock for 22 1/2 then sell the $25 option you would receive the premium for the option and have the potential capital appreciation in the stock, up to the strike price of 25. So you could earn 3 1/2 points on this trade. If you purchased one round lot (100 shares) and sold one contract your return would be $350. Now if you maximized your leverage and purchased the stock using 50% margin, you would purchase the stock for $1125. So the gain of $350 on an $1125 investment equals 31.1% return. That is assuming the stock price rises to at least 25 and you're called out. Any gain above the strike price doesn't benefit you, but the holder of the option. If the stock price remains flat until expiration and you aren't called out, you still earn the option premium of one dollar. So a $100 return on an $1125 investment equals 8.8%, even if the stock price doesn't move. At the expiration you can then sell another option or sell the stock and look for another one. But wait! What if the stock price falls? That's always the risk, isn't it? But even then, the price could drop to 21 1/2 and you'd still break even. You gained the $1 premium for the option. It is this principle that makes covered calls safer than most investments. But what if the stock price falls below the break-even point, you're doomed right? Not necessarily. There are some protective actions you can take. The simplest thing to do is close out the position. This should be your action if you think the price will continue to decline. Bite the bullet, pull the trigger, move on. Another action you could take is roll down. When the underlying stock drops in price, buy back the original call -- it will certainly be less than you sold it for since the underlying stock has declined -- then sell a call with a lower strike price. This could give you some more downside protection and might turn the deal into a profit. Example: If you bought ABC stock for 25 1/2 and sold the May 25 call at 3, you would have maximum profit potential at expiration of 2 1/2 points. Your downside protection is 3 points, down to a price of 22 1/2. If the stock price drops to 22 1/2 the May 25 call might be selling for 1/2, and the May 22 1/2 call might be around 2. At this point, you'd be 2 1/2 points below the strike price and have a 1/2 point unrealized loss. If the stock should continue to fall from this level, you could have a greater loss at expiration. What to do? Here's one salvage technique. You could buy back the original call for 1/2 (you sold it for 3, remember), then sell the 22 1/2 call for 2. Now your downside breakeven point is 21 since you rolled down. Further if the stock remained unchanged (exactly at 22 1/2) until expiration you would make an additional $150. If you had not rolled down, and ABC remained at 22 1/2, the most you could have made would be the remaining 1/2 from the May 25 call. So rolling down gives you a little more downside protection and might produce additional income if the stock price firms. The only time it doesn't pay to roll down is when the stock reverses and begins to climb. There just is no way around the equation: lower risk = lower potential return, higher risk = higher potential return. What if the stock rises? A more pleasant problem to deal with is one in which the underlying stock rises in price after the covered position is in place. You might decide to do nothing and let the stock be called away, thus earning exactly what you anticipated when you entered the position. On the other hand, you might try to squeeze another point or two out of it. Let's say you bought ABC stock for 25 and sold a Nov 25 call for 3 points. Your maximum profit potential is 3 points and your breakeven point is 22. Suppose the stock rallies to 30 in a short period of time. With the stock at 30 the Dec 25 might be selling for 5 1/2 and the Dec 30 might sell for 3 1/2. What you might consider is buy back the original Dec 25 call for 5 1/2 and sell the Dec 30 for 3 1/2. This would increase your profit potential. In your original position, if ABC were called away you would have earned 3 points. By rolling up you would have earned the original 3 points plus the 3 1/2 points gained in the roll up, minus the 5 1/2 you had to pay to buy back the original call. You also would gain the 5 points increase in the stock price. So add the 5 points earned on the stock plus the 1 profit on the options, and your net return is 6 points, as long as the stock remains above 30. To increase your profit potential in this manner, you give up some of your downside protection. This element of risk should always be considered. Generally you should not roll up if you think the stock can't handle a 10% correction and still leave you in good shape.

In-The-Money Covered call writing is generally considered to be a conservative strategy. This is because the covered writer would fair better in a stock decline than the stockholder who won't receive any premiums from covered writes. But clearly, some covered writes are more conservative than others. It may be surprising, but writing an out-of-the-money option on a conservative stock is NOT as conservative as writing an in-the-money option on a volatile stock. An in-the-money write, when properly chosen is a totally conservative position. Now surely, you can't write them too deeply in the money allowing for total protection, the yields would be so low that you might as well leave your money in the bank. The conservative covered call writer strives to make an above average return with above average protection. Example: Assume ABC stock is selling for 22 1/2 and the Jun 20 call is selling at 4. By using leverage from your margin account, the stock could be bought for $1125. You would receive $400 for the option. When you're called out you will have to sell your stock for $20, that's 2 1/2 points less than you paid for it. So your net is 1 1/2 points ($150) on an $1125 investment. That equals 13.3% yield. Now look at the protection you have. The stock price can fall 2 1/2 points and the trade still work out as planned. You will be called away and you've earned the premium. If the stock is at-the-money and you're not called out, then you can sell the stock or do another covered write. Your breakeven point is 18 1/2 which means the stock would have to fall nearly 20% for this to turn into a losing trade. The downside to in-the-money covered calls is that you don't benefit from any upside potential of the stock. But in a flat market, or even a bearish market, there is great comfort in those in-the-money covered calls. Great comfort. Many investors reconcile themselves that they are after 8-15% per month and want safety first. They never concern themselves with the rising price of a stock. They simply want to get called out of their position and look for another trade that will earn them another 8-10% in a month or so, and they consistently have yields of 100% per year.   Strategies Covered Call Writing Long Stock + Short Call  Component Buy stock and sell at-the-money call Potential Profit When stock price is above break-even point Limited to premium received Maximum Loss When stock price is below break-even point Substantial, equals to break-even point minus stock price Time Value Impact Positive Break-even Strike price minus premium received The combined position is a synthetic short put. Compared with holding stock only, loss would be reduced by the amount of premium received when the stock price drops. But profit is limited to premium received.   Example:  Component Buy ABC stock at $200 and sell ABC Jan $200 Call, receive $15 Net Premium Receive $15 Break-even $200-$15=$185 Profit when Stock price is above $185 Potential Profit $15 Potential Loss $185 - stock price Time Value Impact Positive