Covered call writing is a method of hedging (reducing the risk of owning) a long stock position by selling one call option for each 100 shares owned. The term “write” refers to “writing a contract” and is equivalent to selling a contract.
When you sell the call:
1. A cash premium is collected. That cash is an immediate bonus for selling the call, and is yours to keep — no matter what else happens.
2. You accept a conditional obligation to sell 100 shares of stock (per option): At the strike price and for a limited time (until the third Friday of the month specified in the option contract).
Let’s say you own 300 shares of XYZ stock, currently trading ay $34 per share. You decide to sell three XYZ Aug 35 Calls, collecting a premium of $150 for each option. The $450 (less commission) is yours to keep.
Each XYZ Aug 35 Call gives its owner the right to buy 100 shares of XYZ at $35 per share at any time through the third Friday of August.
What’s the story on the “conditional obligation”? The call owner has the right (but he/she does not always exercise this right) to exercise the option, thereby forcing you to honor the terms of the contract. By exercising, the call owner buys your stock at $35 per share — and you are obligated to sell. Because the call owner may decide not to exercise, you may not be required to fulfill your obligation.
If XYZ is trading lower than $35 when the market closes for trading on the third Friday of August, there is no reason for the call owner to buy your shares. After all, those shares can be bought in the open market at a lower price, and the call owner will not elect to pay a higher price.
If the calls are exercised, you are assigned an exercise notice (before the market opens in the morning), which informs you that your shares were sold and the cash has been deposited into your account. At expiration, your broker notifies you Sunday or Monday.
If you prefer not to sell the shares, you may repurchase the options sold earlier (i.e., buy three XYZ Aug 35 Calls). That trade closes your option position and you can no longer be assigned an exercise notice. Please note: Once you are assigned that notice, it is too late to buy the calls. An exercise or assignment is irrevocable. You can repurchase the shares, but you cannot keep the old shares.
If expiration comes and goes, and you do not receive an exercise notice (do not expect to receive it Saturday; it is available Sunday or Monday), then the option has expired and is now worthless. Your obligation to sell shares is canceled. By selling the options you earned an extra $450 (in this example). You may, if you choose, sell three more options and repeat the process.
To the novice, this looks like free money: Sell options, see them expire worthless and reap the rewards. It’s not that simple. Sometimes the stock moves higher and you sell the shares when you would prefer to own them.
The bigger problem is that markets do decline, and a substantial loss may be sustained. It’s a smaller loss than the stockholder who did not sell calls, but this strategy is not risk free.
Covered call writing is used by experienced investors, especially those who come from a background of buy-and-hold investing. Writing covered calls has mass appeal, and there is no shortage of people who want to sell their covered call writing selections. Please don’t buy those “picks.” If you adopt this strategy, please choose stocks you want to own. Do not get dazzled by high option premiums because such stocks are risky to own.
Follow Mark Wolfinger on Twitter @MarkWolfinger.
See Part III: How to Choose the Right Option to Sell
