Option Strategies: Covered Calls

The covered call strategy is when an investor writes a call contract while owning a significant amount of the underlying stock. If the stock is purchased at the same time as the call contract is written, then the strategy is often called “buy-write.” If the stock was previously purchased, then the strategy is often called “overwriting.” In both cases, the stock used is usually in the same economic account where the investor wrote the call contract. These stocks are fully collateralized for the obligation contained in the written call contract. This is also called “covering.” This strategy is the most basic and widely used strategy to take advantage of the flexibility of listed options and stock ownership.

When to use?

Although the covered call strategy can be used in any market situation, it is more often used when the investor is bullish on the underlying stock and believes that the stock price will change little during the life of the call contract. The investor either wants to obtain additional income from the underlying stock beyond dividends, or (at the same time) provide limited protection against a decline in the underlying stock price.

benefit?

This strategy provides limited protection from a decline in the underlying stock price and limited profit opportunities from an increase in the stock price. But the benefit it generates is the premium the investor receives from writing the call contract. At the same time, if the investor is not assigned an exercise notice for the written call and is forced to sell his stock, he still retains all the benefits of ownership of the underlying stock, such as dividends and voting rights. Because covered calls reduce the risk of stock ownership, this strategy is widely considered to be a conservative one.

Risks and benefits?

Maximum loss: Purchase price of limited shares – Strike price + Premium paid

Potential loss: Huge

Cap profit if assigned at expiration date: Premium received + difference between exercise price and stock purchase price (if any)

Cap profit if not assigned at expiration: any gain in stock value + premium received

This strategy generates the highest profits when the underlying stock you own reaches or exceeds the call option’s strike price. This is when you are assigned an exercise notice on the call option, either on the expiration date or before the expiration date. The real risk of financial loss with this strategy comes from the stock the investor owns. This loss can be significant if the stock price continues to decline when the written call option expires. On the call option expiration date, the loss is equal to the initial stock purchase price, less the current market price, less the premium of the initial sale of the call option contract. Any loss caused by a decline in the stock price is offset by the premium from the initial sale of the call option. As long as the underlying stock is not sold, this loss is an unrealized loss. Being assigned an exercise notice on the written call option is possible at any time. An investor who owns stocks purchased at low prices should consult his tax advisor to understand the tax consequences of writing call options on these stocks.

Break-even point?

Break-even point: Stock purchase price – Premium received

Volatility?

If volatility increases: negative effect If volatility decreases: positive effect

The impact of volatility on the total premium of an option is the time value component.

Time weakening?

The Passage of Time: Positive Effects

As time passes, the time value portion of an option premium generally decreases – a positive effect for investors with short option positions.

What are the other options before the expiration date?

If the put option is worthless at expiration, no action is required. The investor will continue to hold his stock. If the option goes into the money before expiration, the investor can exercise his right to sell the underlying stock at the put option’s strike price. Alternatively, if the option has market value, the investor can sell the put option before the market closes on the option’s last trading day. The premium received from selling the long option can offset the loss caused by a decline in the underlying stock price.

What are the other options at the expiry date?

As the expiration date of a call option approaches, the investor considers three scenarios and then makes a decision accordingly. The written call contract may be in-the-money, at-the-money, or out-of-the-money. If the investor believes that the written call option will be in-the-money at expiration, he may elect to be assigned an exercise notice on the contract and sell the corresponding number of shares at the strike price of the option. His other option is to close out the written call option with a closing purchase transaction, relieving him of his obligation to sell the shares at the strike price of the option and retaining the shares he holds. Before taking such action, the investor should compare any realized profit or loss on such transaction with the unrealized profit or loss on the underlying shares held. If the investor believes that the written call option will be out-of-the-money at expiration, then he need not take any action. He may let the call option expire worthless and retain the entire premium received when the option was originally sold. If the written call option happens to be at-the-money at expiration, then the investor should be aware that exercise assignments on such a contract are possible, but should not be assumed to occur. Talk to your brokerage firm or financial advisor about what actions to take in this situation.