The Basics of Covered Call Options

ccbasicsWriting (selling) Covered Calls

Unlike the writing of naked (uncovered) calls, which has limited profit potential and virtually unlimited risk, the writing of covered calls is one of the most conservative ways to participate in the options game.

In order to write covered calls, one must not only own the stock that they will be using to collateralize (“cover”) the option, and they must own it in round lots of 100 shares for each contract they intend to write.

For example, an investor who owns 350 shares of a stock would only be allowed to write three (3) covered calls (against the first 300 shares of the position) since the last 50 shares would not represent enough collateral to cover another contract (each contract represents 100 shares).

Though the strategy of writing covered calls against an existing position can be used effectively in any market environment, it is most often employed by investors who are bullish on a stock’s long-term potential but neutral or bearish about the near-term outlook.

In addition, while the financial impact on one’s portfolio turns out to be the same regardless of the reason why they decided to write covered calls against their stock, investors often approach this strategy from one of two angles (or perhaps a combination of the two under certain circumstances).

Reducing Downside Risk With Covered Calls

The first way to look at covered call writing is as a way to reduce downside risk.

For example, let’s pretend Nervous Nate owns 100 shares of XYZ Corp., and true to his reputation, he starts to get nervous about next month’s earnings report a full seven weeks before it is going to be released. Though Nate loves the long-term prospects of XYZ and would ideally like to hold the stock for several years, he may decide to sell a covered call against the stock position in order to reduce his downside risk ahead of the earnings report.

And, getting more specific, let’s assume that XYZ is currently trading at $31.50… and that, if he chooses to, Nate can write a covered call with a strike price of $35 that expires in just under two months for $1.50 (really $150, since each contract represents not 1, but 100 shares).

If Nate somehow finds the courage to just ride out whatever fate befalls the stock after the earnings report (i.e. he decides not to write the call), the possible outcomes for his portfolio over the next two months can be summarized as follows:

• if the stock is below $31.50, he will have lost money relative to where things are today (and will still own the stock)

• if the stock is above $31.50, he will have made money (and still owns the stock)

• if the stock is still trading at $31.50, he will have broken even (and still owns the stock)

On the other hand, if Nate decides to “play it safe” and writes the call after all, his list of possible outcomes looks like this:

• if the stock is below $30 (not $31.50 anymore – Nate has bought himself an extra buck-fifty of downside protection!), he will have lost money (but still owns the stock)

• if the stock is above $30 (not $31.50!) he will have made money… and if the stock is still below $35, he will continue to own the stock (a wonderful source of worry for Nate – and what would he do with himself  if he didn’t own any stocks to worry about?!)

• and, if the stock is above $35, he will no longer own the stock because it will get called away from him at that price – but Nate won’t mind because he made $350 on the stock over those two months and pocketed $150 from writing the call, giving him a gain of almost 16% in a two month period (which makes Nate smile… even if only for a moment or two).

Generating Income With Covered Calls

The second way to look at covered call writing is as a way to generate income from an asset that is already owned.

For example, let’s say that Income Irene also owns 100 shares of XYZ Corp. (again selling at $31.50), a she, too, comes to the realization that she can write a covered call with a strike price of $35 that expires in just under two months for $1.50.

Just like above, If Irene does not write the call, her possible outcomes are:

• stock below $31.50 = lost money (but still owns the stock)

• stock above $31.50 = made money (but still owns the stock)

• stock at $31.50 = broke even (but still owns the stock)

On the other hand, if Irene goes after the income and writes the call, her possible outcomes are:

• if the stock is between $30 and $35 at expiration, she will still own his stock and will have pocketed the $150 she collected for writing the option on stock she was going to own anyway for those two months

• if the stock is above $35, she will have pocketed the $150 as income and realized another 11% appreciation on her stock investment over those two months. Of course, she no longer owns the stock, but Irene is content because she realizes that a 16% combined return in just two months isn’t too shabby (even if she ends up owing some of the gain in taxes)

• if the stock is below $30, she will have lost money (but still owns the stock)

Conclusions About Covered Call Writing

As you can see, even though their reasons for writing covered calls are different (“hedging” vs. “income generation”), the possible financial outcomes for Nervous Nate and Income Irene are the same… and hopefully this helps reinforce the idea that regardless of which angle an investor chooses to approach the strategy from, it really just boils down to “a numbers game” in which an investor simply aims to figure out which set(s) of numbers most closely addresses their needs and desires when it comes to balancing risk and reward.

In addition, however, if you plan on writing calls against stock that you really are hoping to hold for years, it is very, very important to keep in mind that one of the biggest risks when writing covered calls is that your stock might get called away from you in the early stages of a bull move for the stock, thus resulting in a huge “missed opportunity cost” as the stock continues to rise. If this is of concern to you, you may want to consider keeping a small pool of money handy that can be used to repurchase (probably at a loss) any contracts you have written that appear to be headed for exercise by their holders (which, in many ways, is not a bad way to go since you get to write-off the short-term loss on the option while holding on to your stock that you would otherwise owe capital gains taxes on if it is sold).