Options Made Simple: Selling Covered Calls

by Alex Hanson | January 30, 2012 9:49 am

Options Made Simple: Selling Covered Calls

I have worked in the options business — in some form or another — since one year out of college (sadly, that’s a lot of years). I’ve seen the industry boom and the intrigue grow, but there still are far more investors who fear and avoid options rather than accept them as an alternative way to hedge one’s portfolio and potentially reduce risk.

I’m an options evangelist, if you will, and believe almost any stock trader out there can benefit from a bit of options education. Whether you’re seeking aggressive growth or conservative ways to help your portfolio, there’s likely a strategy for you. Today, I’d like to quickly break down one of the more basic and conservative strategies: the covered call. This also is a strategy many stock traders use when dipping their proverbial toes into the option-trading pool.

Almost every investor among us has been in the following situation: You’ve purchased a stock, your bullish thesis is applicable in the long term (or even the intermediate term), but you are a little nervous about the next few weeks. Maybe an earnings report is coming out or a macroeconomic situation (an election, Fed decision) is cause for trepidation. You don’t want to sell out of the position, incurring commission fees (and surrendering potential upside), but you don’t want to willingly accept near-term losses. The covered-call strategy can be a good solution in this scenario.

Typically, a covered call involves the sale of an upside (out-of-the-money) call, providing a small cushion for the stock to move a bit higher (see the specific example later). When a call is sold against an existing long stock position, the strategy is called a “covered call.” On occasions when the trades are made simultaneously, the strategy is sometimes referred to as a “buy-write,” but we’ll get to that in a later article.

A covered-call strategy basically has three scenarios — decent, better and best. Let’s walk through these outcomes.

Hypothetical Example

Michael owns 100 shares of XYZ stock that he bought at $120. The stock has been on a tear and now is trading around $190. Despite this nice gain, the stock has shown some short-term weakness, and Michael doesn’t want to lose any more of his profits. He sells one March 200-strike call, collecting $3 for the contract.

Option premiums will be more expensive depending on proximity of the stock price to the strike price, time until expiration and volatility expectations. More volatility means higher prices, which can be frustrating for option buyers but benefit option sellers, as they collect more with each trade.

By March expiration about two months out, one of three things can happen.

The best: The stock can stay put or rise as high as the 200 strike, about a 5% advance. Michael keeps any additional gains in the stock plus the $3 credit for selling the call. He also keeps XYZ in his portfolio.

The better: If the stock continues to decline, the sold call option expires worthless, reducing any loss Michael suffers in his long stock position by $3. In both of these scenarios, Michael is better off for having employed the strategy as opposed to standing idly by holding only the long stock.

The decent: If, however, XYZ does better than Michael hoped, rising above the $200 level before March expiration, the option could be exercised, forcing him to deliver his shares to the call buyer. This requires no additional capital outlay on his part — the call is “covered” (get it?) by the shares he already owns. Michael’s gain was limited to the additional gains in the stock up to $200 — plus the sold call credit — and he no longer owns the shares. But for some investors, the “opportunity cost” of missing out on a gain in the underlying stock is a small price to pay for peace of mind.

No matter what scenario, as expiration approached, Michael could always opt to roll his short call to a later month (and potentially a higher strike) or buy the call back, closing the position.

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