Covered call

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A covered call is an investment strategy involving the purchase of a security, and the sale of call options representing the same amount of the security.

Establishing the Position

A covered call requires two components. The trader must purchase (be long) a security; for example, shares of stock or a futures contract. The trader also sells a call option at a strike price that is above the point of entry for the security.

For example, the trader buys 100 shares of Dave's Fun Company at $50/share, and then sells a single 55 call. Since stock options represent 100 shares, the option and the shares themselves represent an equal amount of the security.

The trader receives a premium for the sale of the option. The premium's exact amount varies greatly depending on the difference between the security's current value and the strike price of the option; the time left to expiration and the volatility in the security's price. In exchange for the premium, the trader assumes the risk and obligation to take a short position at the strike price if the option is exercised by the buyer.[1]

Note that while covered calls can be created with commodity futures contracts as well as stocks, it is arguably less desirable and effective to do so. Since futures contracts also expire, the strategy of "sell calls while we wait for the price to rise" is less effective. In addition, commodity prices are not long-biased as stocks are, so the required buy-and-hold strategy is less common and often more painful in futures markets that can quickly make major price changes in both directions.

The Ideal Scenario

The intention in a covered call is to produce small amounts of income from the sale of the call options, while holding onto a security whose price is declining, neutral, or rising slowly. Since options have a limited duration, the hope is to have the option expire without the buyer having a profitable opportunity to exercise it. In such cases, the seller keeps the premium and is freed from the option's risk upon expiration.[2]

With one option expired, the trader is free to sell a new call option to create a new covered call trade, selecting a new strike price as appropriate. So long as the options continue to expire worthless, the covered call scenario can be continued indefinitely.

The ideal scenario for this strategy is to have the price rise steadily and slowly. When buying a stock at $50 and selling a 55 call, the best possible case would be to have the market close at $54.99 on the day of expiration. The 55 call will expire worthless, but the stock is worth more than when it was purchased. The trader is therefore holding an appreciating asset, and is also making a little extra from the sale of the call.

Risk Analysis

Covered calls have limited profitability, and loss limited only by the zero point of the security.[3]

Decline of security price

The goal in this type of trade is to have the security protect against the risk in selling the options, not the other way around. The covered call combination does not mitigate the risk of loss in the security if the market price falls substantially.

In the above example, the trader that bought 100 shares of Dave's Fun Company at $50 has spent $5,000 plus transaction costs. Selling the 55 call might yield $100-$300 in premium. If Dave's Fun Company goes out of business tomorrow and the stock's value drops to zero, then the trader will lose 95 percent of his investment, instead of the full 100 percent, because of the premium that was collected. While the numbers aren't the same in a spreadsheet, the trader probably will still say, "I lost everything on that Dave's trade."

Rapid Rise in Security Price

Assuming that there is an equal number of shares held and represented by the options (e.g. 100 shares for every 100-share option), then the loss is limited to transaction costs and future opportunity. The trade in this case will return a limited profit.

Let's look again at our trader who owns 100 shares of Dave's at $50, and who received $200 for the sale of the 55 call. The world discovers that Dave's company is indeed fun, and the price jumps overnight to $60. The buyer of the option exercises his option and receives 100 shares of Dave's at 55, his strike price. Our trader has to take the other side of that transaction, and has to sell 100 shares of Dave's at 55.

The net result for the security is a $5/share return, since the trader bought at $50 and sold at $55. Since the option has been exercised, the trader keeps the $200 premium. The net return for the transaction is therefore $700, minus the transaction costs.

While positive, the trader is no longer holding the security, so if the goal was to squeeze profit from a buy-and-hold strategy, then the trade has failed. With the share price at $60, the trader has gained money but lost the opportunity for more.

Minimal Changes In Security Price

From a strictly numeric viewpoint, this situation is ideal for managing risk with covered calls. If the stock purchased at $50 is still at $50 when the call expires, then premiums can be collected again and again by selling a new call as each one expires.

From a portfolio management perspective, this may make less sense. Owning a stock that doesn't rise in value, or trades year after year in a very narrow range, may not be the best use of available funds. Investors who have stagnant stock might be tempted to sell calls while waiting for the stock to wake up and move again, but if the stock suddenly moves rapidly upward, there's a substantial risk that the call will be exercised and remove the stock from the portfolio at precisely the time when it is becoming more valuable.

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References

  1. Equity Option Strategies - Covered Calls. Chicago Board Options Exchange.
  2. Options Strategies: Covered Call. The Options Industry Council.
  3. Stay Away From Covered Calls. The Motley Fool.