FIRST TIME VISITORS! CLICK HERE!Reprinted from The Options Industry Counsel
Covered Calls
Strategy of the Month - Writing Covered Calls
Who Should Consider Using Covered Calls? by Riva Aidus Hemmond Chicago Board Options Exchange for The Options Industry Council This strategy would work equally well for cash, margin, Keogh account or IRA. Although this strategy may not be suitable for everyone, any of the investors above may benefit from using the covered call.
- An investor who is neutral to moderately bullish on some of the equities in his portfolio.
- An investor who is willing to limit his upside potential in exchange for some downside protection.
- An investor who would like to be paid for assuming the obligation of selling a particular stock at a specified price.
Definition
Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is "paid" to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.
How to Use Covered Calls
If an investor is neutral to moderately bullish on a stock currently owned, the covered call might be a strategy he would consider. Let's say that 100 shares are currently held in his account. If the investor was to sell one slightly out-of-the-money call, he would be paid a premium to be obligated to sell the stock at a predetermined price, the strike price. In addition to receiving the premium, the investor would also continue to receive the dividends (if any) as long as he still owns the stock.
The covered call can also be used if the investor is considering buying a stock on which he is moderately bullish for the near term. A call could be sold at the same time the stock is purchased. The premium collected reduces the effective cost of the stock and he will continue to collect dividends (if any) or as long as the stock is held.
In either case the investor is at risk of losing the stock if it rises above the strike price. Remember, in exchange for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you will see in the following example, even though he has given up some upside potential there can still be a good return on the investment.
Stock ZYX currently is priced at 41-7/8, and the investor thinks this might be a good purchase. The three-month 45 calls can be sold for 1-1/4. Historically, ZYX has paid a quarterly dividend of 25 cents. By selling the three-month 45 calls the investor is agreeing to sell ZYX at 45 should the owner of the call decide to exercise his right to buy the stock. Keep in mind that the call owner may exercise the option if the stock is above 45, because he or she will be able to buy the stock for less than it is currently trading for in the open market. But, as you will see, your return will be greater than if you had held the stock until it reached 45 and then sold it at that price.
Let's take a look at what happens to a covered call position as the underlying stock moves up or down. Commissions have not been taken into consideration in these examples; however, they can have a significant effect on your returns.
Buying 100 ZYX at 41-7/8 and Selling 1 Three Month 45 Call at 1-1/4
1. ZYX remains below 45 between now and expiration - call not assigned.
The call option will expire worthless. The premium of 1-1/4 and the stock position will be retained. In effect, you have paid 40-5/8 (which is also the breakeven price) for ZYX (41-7/8 purchase cost - 1-1/4 premium received for sale of call). This would be offset by any dividends that were received, which in this example would be $.25.
When the ZYX call expires worthless, the covered call writer can sell another call going further out in time taking in additional premium. Once again, this produces an even lower purchase cost or break-even.
If ZYX remains below 45 for an entire year, the investor can sell these calls four times. For this example we will make the hypothetical assumption that the price of the stock and option premiums remain constant throughout the year.
1-1/4 (Call Premium Received) x 4 = $5 Premium + any dividends paid = Total Income.
II. ZYX rises above 45 between now and expiration - call assigned.
The call buyer can excise his right to buy the stock and the call seller will have to sell ZYX at 45, even though ZYX has risen above 45. But remember the call seller has taken in the premium of the call and has been earning dividends (if any) on the stock.
If the stock is called away at expiration:
Receive 45 for stock $4,500.00
1-1/4 Premium 125.00
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$4,625.00
Less: 41-7/8 Stock Cost ($4,187.50)
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Return: 10.5% $437.50** in three months plus dividends (if any) received.
III. ZYX is right at 45 at expiration.
The seller of a call may be in situation I or II. The stock may be called away and the call writer will be obligated to sell ZYX at 45. Alternatively, the stock may not be called away. A call could then be sold going further out in time, bringing in additional premium and further reducing the break-even point.
Summary
The covered call write is a strategy that has the ability to meet the needs of a wide range of investors. It can be used in your Keogh, margin, cash account or IRA against stock you already own or are planning on buying. Currently, there are short-term options listed on more than 1,700 stocks and more than 200 of those stocks also have LEAPS (Long-term Equity AnticiPation Securities) which are simply long-term stock and index options. Today's investor has a choice of short-term and long-term expirations, as well as multiple strike prices. This strategy is actually more conservative than just buying stock, due to the fact that you have taken in premium and lowered your break-even price on the stock position. The covered write allows you to be paid for assuming the obligation of selling a particular stock at a specified price.
The statements contained in this article reflect the opinion of the author and should not be taken as statements of fact or as opinions or recommendations of any of the Options Industry Council, its Exchange members or The Options Clearing Corporation. This article is not time sensitive and may not reflect current market conditions. Options involve risks and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker or from any of the exchanges listed on our home page. A prospectus, which discusses the role of The Options Clearing Corporation, is also available without charge upon request addressed to The Options Clearing Corporation, 440 S. LaSalle St., Suite 2400, Chicago, IL 60605, or to any exchange on which options are traded.
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