Covered Calls

Who Should Consider Writing Covered Equity Calls?

• An investor who is neutral to moderately bullish on certain portfolio holdings.
  
   
• An investor willing to limit upside profit potential on a specific stock holding in exchange for limited downside protection.
  
   
• An investor who wishes to generate income in addition to any dividends from shares of underlying stock owned.

This strategy is one of the most basic and widely used that combines the flexibility of listed equity options with the benefits of stock ownership. It works well for cash, margin, and Keogh accounts or IRAs. Although this strategy may not be suitable for everyone, it can provide a stock-owning investor limited downside stock price protection in return for limited participation on the upside. In addition, the covered call generates income from the premium received from the call contract's sale that can supplement any dividend income paid to eligible underlying stockholders.

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 covered by underlying shares currently held by an investor. Generally, one call option is written for every 100 shares of stock owned. The writer receives cash for selling the call but will be obligated to sell the stock at the call's strike price if assigned, thereby capping further upside stock price participation. In other words, an investor is "paid" for agreeing to sell his holdings at a certain level (the strike price). For this reason the covered call is considered a neutral to moderately bullish strategy. On the downside, limited stock price protection is provided by the premium received from the call's sale.

The upside profit potential if assigned is limited to the premium received from the call's sale plus the difference between its strike price and the stock purchase price. If assignment is not received and the call expires out-of-the-money and with no value, the upside profit potential is any gain in share value plus the premium received. The downside loss potential is substantial and comes entirely from owning the underlying shares and is limited only by the stock declining to zero. The break-even point is an underlying stock price equal to the purchase price of the underlying shares less the premium received. As with any short option position an increase in volatility has a negative financial effect on the covered call while decreasing volatility has a positive effect. Time decay has a positive effect.

 

How to Use Covered Calls

Let's say that an investor holds 100 previously purchased shares of stock, and has either a neutral or slightly bullish market opinion on its price over a given period of time. A call is selected with a strike price, usually out-of-the-money, at which the investor is comfortable selling his shares if assigned, and that can be sold for a premium that provides downside stock price protection that fits his tolerance for risk. The expiration month reflects the time frame of his market opinion. If the investor is particularly bearish on this stock then he might choose another strategy, such as a protective put, which offers more protection from a declining share price. If particularly bullish, then he might choose to leave the stock uncovered for the unlimited upside profit potential that shares offer.

A call could also be written at the same time underlying shares are bought, and the criteria used in considering which call to sell would be similar. Whether the call is written on previously purchased shares, or simultaneously with a new stock purchase, the premium collected reduces the effective cost of the stock. The investor will also continue to collect dividends (if any) as long as the stock is owned.

Writing a Covered Call to Generate Income and Provide Limited Downside Protection

Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.

Example

An investor has purchased 100 shares of ZYX at a share price of $41.75. He thinks the stock might trade for this amount, or moderately higher or lower, over the near term so he writes an out-of-the-money, three-month ZYX 45 call for $1.25. By selling the $45 call, the investor is agreeing to sell ZYX at $45 should the stock increase above this amount and he is assigned. Participation in a ZYX stock increase is therefore capped at $45 per share.

If the price of ZYX stock declines significantly below the purchase price of $41.75, the investor will incur an unrealized loss on the 100 shares owned. However, this loss can be at least partially offset by the premium of $1.25 per share taken in at the call's initial sale. The break-even point for this strategy is a ZYX price of $41.75 (stock purchase price) - $1.25 (option sale price), or $40.50. In other words, this $1.25 represents the amount of downside price protection on the ZYX shares.

Before option expiration early assignment is always possible. If assignment is received on or before the ex-dividend date then the investor is obligated to sell his 100 ZYX shares and will not be eligible to receive the regular dividend paid to shareholders.

Consider three possible scenarios at expiration:

• ZYX closes below the strike price at expiration
• ZYX closes above the strike price at expiration
• Assignment before expiration

ZYX closes below 45 at expiration - no assignment on short call

In this case, the call option will expire worthless and the investor keeps the premium of $1.25, or $125 total, for the call contract. Since there is no assignment, the 100 ZYX shares will be retained as well. However, the net effective cost of the shares is reduced by the premium taken in. The result is a net share cost of: $41.75 stock purchase price - $1.25 call premium received = $40.50 net. Any dividends paid during the lifetime of the call contract would be kept as well.

If at expiration ZYX closed above the stock purchase price of $41.75 both the covered call writer and the stock investor not writing a call would see a profit on the 100 shares. However, only the call writer?s return would be increased by the $125 option premium received. If at expiration ZYX closed below the stock purchase price both investors would see a loss on the 100 shares, but only the call writer would have the loss at least partially offset by the premium taken in.

After expiration, the covered call writer is now free to write another call covered by the 100 ZYX shares, and can choose a strike price and expiration month that fit his current market opinion and time frame for it. By doing so, taking in additional premium results in an even lower net purchase cost for the 100 shares, generates additional premium income, and provides limited downside stock price protection for the lifetime of the newly written call contract.

ZYX closes above 45 at expiration - assignment on short call

In this case, the short call will expire in-the-money and the call writer can expect assignment. No matter how high ZYX has risen, the investor is obligated to sell his shares at the strike price of $45 per share so the upside profit potential on the shares is capped. However, the investor keeps the option premium received and will realize the position's maximum profit calculated in advance. This amount would be: ($45 strike price - $41.75 stock purchase price) + $1.25 call premium received = $4.50, or $450 total. Any dividends received before expiration would increase this profit amount.

Consider the overall return on this covered call position for the three-month life of contract if the stock is called away at expiration:

The covered call writer's profit of $450 would represent a return on his initial $4,050 investment of approximately 11.1% over the three-month life of the call contract. A stock investor purchasing 100 ZYX shares at the same $41.75 per share, not writing a call, and selling the shares at $45 would see a profit of $325. This would represent a return on his investment of only approximately 7.8%.

Before expiration the price of ZYX stock might rise well above the $45 strike price, and assignment at expiration seems likely but undesirable. In this case the investor may make a closing purchase of the ZYX 45 call at any time before it expires. The result would be an unrealized profit on the ZYX shares offset partially by a losing transaction on the option repurchase, but the investor retains his shares with the possibility of continued profits on the upside.