by John Jagerson | April 20, 2011 7:07 am
The core principle of writing covered calls is that you are controlling risk and attempting to improve returns on a stock or exchange-traded fund (ETF) that you own.
You can do this by selling a call option against that stock or ETF and collecting the option premium. A covered call consists of a two-step process that is easy to implement by new and experienced investors alike.
The first step in writing a covered call is to be long the underlying stock or ETF.
Sometimes investors are selling a covered call against a stock they may have owned for a long time, and other times an investor may be buying the stock and selling the call option at the same time, which is sometimes called a “buy-write.”
The second step in writing a covered call is to sell a call against that long stock or ETF position.
There are several factors to consider when you are selling the call, including expiration date, strike price and premium. In this article we will walk through a case study of a covered call to begin answering these questions.
Before we begin, you may want to check out part one of this series on selling options.
Imagine you own 500 shares of Apple Inc. (NASDAQ: AAPL) and you want to sell five call contracts to make some income from those option’s premiums. That trade is a covered call.
The covered call is “covered” because you already own the stock. If prices rise and the call buyer wants to purchase the stock, you have the ability to fulfill on the contract without going to the open market because you already own the stock. This alleviates the problems with selling a call alone that we discussed in part one of this series.
Let’s assume you had owned 500 shares of AAPL in late March 2008, when the stock was priced at $140, and sold a call against it with a strike price of $145 and a premium of $6 per share, or $600 per contract.
As the seller, you were paid $600 of premium per contract for five contracts of AAPL calls you sold, for a total of $3,000. That sounds good so far — you made three grand.
However, let’s now look at what happened to those options you sold at expiration, when that obligation to deliver the stock was due.
By April’s expiration the stock is at $155 per share and the call buyer wants the stock. She has the right to buy it for the strike price of the calls, or $145. As detailed above, you already own it and your broker would just take it out of your account automatically.
You bought the shares of AAPL for $140, so by selling it for $145, you made an additional $5 per share, or $2,500, plus you keep the premium for the calls of $3,000. A good profit, but the downside of the option is that by selling the right to buy at the $145 strike price, you missed out on another $10 per share on the rise in the price of the underlying stock.
The advantage of owning the stock was that is protected you from the liability created by the big breakout in April. Otherwise, you would have been responsible for acquiring the stock on the open market for $155, which you would have had to sell for the $145 strike price.
The difference is substantial, in that the covered call was a profitable trade, whereas just writing a call without owning the stock would have resulted in a loss.
The advantage of selling the call is not as evident when the market is rising, but really comes into play when prices drop.
Selling the call and earning the premium provided $3 per share of protection against losses. This protection has the effect of reducing account volatility and improving returns. Over the long run, the reduction in losses is well worth the opportunity cost of losing a little upside potential.
In the video below I will look at this situation in more detail and contrast it with other scenarios, including when the stock’s value goes down.
Covered calls are not only a great way to limit your liability as an option writer, but they are an excellent way to hedge risk on your stock holdings as well.
Continue on to the next part of this series on covered calls.
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