A covered call is a call option where you own the underlying stock. This differs from a naked call, where you do not own the stock.

Creating income by writing covered calls

Writing covered calls (a call option contract) is a technique for making money off of a stock that doesn't seem to be moving anywhere, but you are willing to sell once it hits a certain price.

The technique works as follows (Beware, these numbers are illustrative only):

  1. Buy (or already own) 100 shares of Stock A. The market price is currently $50 per share.
  2. There are $55 call option contracts selling for $1. Though the strike price ($55) of the option is less than the market price (out of the money), this option still has value due to the time-value or the option. This value will shrink the closer the option gets to its expiration date. Once an option expires, it is worthless.
  3. I write a call option contract with a strike price of $55, and then sell it for $1 per share, earning $100 less commission.
  4. Wait for the option to expire.

Two things can happen in the meantime:

  1. The price of the stock goes up and exceeds the strike price (in the money). At this point, the owner of the contract (Not you! Remember you sold the contract!) can exercize the option. You must sell the stock to the contract owner at the strike price, regardless of the actual market price of the stock. So if the price jumped to $70, you still have to sell at $55.
  2. The price of the stock doesn't exceed the strike price. Once the contract expires, you are no longer obligated to sell the stock at that price. Congratulations! You and your broker pocketed $100 and you still have the stock you started with.

Pros of this technique:

  • Gets more income (positive cash flow) from a stock than the stock would normally give through dividends.
  • Gives you the effect of setting a sell limit price with you broker, and earning money (through the contracts) as well.

Cons of this technique:

  • If the price should go up quickly (and most major stock moves happen fast), you will not reap the entire benefit. You also cannot change sell limits quickly, like you can with a broker.
  • If the price drops quickly, you may be unable to sell the underlying stock (due to margin limits or not being allowed to have naked calls) or if you do, you are then at a much higher risk of a quick upturn again, since you no longer own the underlying stock. (You've essentially turned a covered call into a naked call.)

The overall result is that you reduce your potential gain, and you also reduce your risk of loss, since you are making money over time.

Just remember, options are a derivative, they do not have any intrinsic value. Please make sure you understand them thoroughly before you invest.

Introduction

A covered call is an option strategy, in other words, it is a combination of an position in an option and a position in the underlying stock. In essence, it consists of a a long stock position, with one short call for each share. In this node, building a covered call, the reason to do so, and the rewards and risks will be discussed.

How to build a covered call position

First of all, one needs to have a position in a stock. It turns out that options, unlike shares, cannot be traded in single units. Rather, each option has a certain contract size. Normally, this is 100, although this should be checked before the trade. So, if you buy one option contract with a listed price of of for instance $2.50, you actually get 100 for $250. Ideally, the share position is divisible by this lot size, so for instance 1200 shares.

The idea is now to sell a call on those shares. A call gives the right to buy the shares at or before a certain time, and for a certain price. As the call is sold, someone else the right to buy the shares from the seller. This is fine, as the seller has those shares.

Which call to sell

On the other hand, if a short-dated call is sold, it is possible to sell more of them, and this typically yields more than one long-dated call. Furthermore, a call with a lower strike is sold, there is more chance it will be exercised, and the seller is forced to sell the shares for less.

Option markets are typically quite efficient, apart perhaps for options with strikes that are far from the current level of the share. As such, it is mostly a matter of opinion which call to sell. Commonly, somewhat out-the-money options (so with a strike that is above the current level of the share) are sold, with a short time to expiry, often one month.

Rewards

The rewards are fairly obvious: we get the premium of the sold call. What this means is that some of the upward potential of the shares is lost, which is compensated by the profit from selling the call. This means that if the share closes lower than the strike, the covered call outperforms the shares; else, it does not.

Risks

The risk of this construction can be seen from two different perspectives. It could be compared to the risk of a naked share position, or it could be compared to having money in a bank earning the risk-free rate.

Compared to a naked share position, a covered call represents mostly an opportunity loss. If the share rises above the strike, selling it was a bad thing. This is especially salient if the share jumps because of a takeover; in this case, selling the call was not a good thing. In any other scenario - including dropping share prices - the covered call outperforms the naked shares. Note that should one want to sell the shares, it is normally best to sell both the shares and buy back the call at the same time, not to be left with the risk of the unhedged call.

Compared to the risk-free rate, this is a rather tricky position. One is exposed to the potential drops in the share price. As such, this position is almost as risky as a naked long position; almost, as the premium received cushions the first lossea. Furthermore, there also is an exposure to dividend and interest. In particular, in case of a dividend, it is possible the shares get exercised, so the new owner receives the dividend. This becomes more likely for a larger dividend. On the other hand, a share going ex-dividend drops in value, making it less likely that the call is exercised after this point, so in principle, an increase in dividend is good, and a decrease is bad. In general, doing a short-dated covered call strategy around a dividend date is tricky.

In principle, a call increases in value if all thing being equal, the underlying share becomes more volatile. This normally happens in a falling market, and in that case, the call loses value because it is less likely to be exercised. It is noted that if the covered call is kept until expiry, this exposure to the volatility is subsumed by the actual value of the call, which is known at exposure.

Conclusion

A covered call offers a way to use options to manipulate the risk profile of a long shares position. In principle, it is a good strategy in a market that is expected to be steady, neither rising nor falling too much. In case of a strongly rising market, there is an opportunity loss; in case of a falling market, the long shares cause a loss, albeit less than a naked long shares position.

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