Covered call

 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 against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to the account. In other words, an investor is ‘paid’ to agree to sell the holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.

The covered call strategy, also known as the buy-write strategy, if used appropriately can be a safe way to make an investor’s portfolio of stocks work for them, especially if the investor intends on holding the portfolio of stocks over the medium to long term.

The covered call is a strategy used to generate income from holding a long position in a stock. Additionally it offers limited protection on a decline in the underlying share price. It is a strategy that is normally executed when an investor who is long on the underlying share has a short term neutral view on its share price. It is also commonly referred to as a ‘buy-write’.

In order to execute the covered call you must ensure you hold sufficient quantities of the underlying, that is if each call option represents 1,000 shares and you are looking at selling 1 call option you must be holding 1,000 shares of the underlying to ensure the call is fully covered. No margins are required to be paid on a covered call.

Covered call writing typically does not meaningfully reduce risk. After the calls are written, the investor is still exposed to a reduction in their wealth dollar-for-dollar for every one dollar decline in the stock price.

How to Use Covered Calls

If an investor is neutral to moderately bullish on a stock currently owned, the covered call might be a strategy to consider. Lets say that 100 shares are currently held in the account. If the investor was to sell one slightly out-of-the-money call, the investor would be paid a premium to be obligated to sell the stock at a predetermined price, the strike price. In addition to receiving the premium, the investor would also continue to receive the dividends (if any) as long as the stock is still owned.

The covered call can also be used if the investor is considering buying a stock on which he is moderately bullish for the near term. A call could. be sold at the same time the stock is purchased. The premium collected reduces the effective cost of the stock and the investor will continue co collect dividends (if any) for as long as the stock is held.

In either case the investor is at risk of losing the stock if it rises above the strike price. Remember, in exchange for receiving the premium for having sold the calls, the investor is obligated to sell the stock. However, as you will see in the following example, even though the investor has given up some upside potential there can still be a good return on the investment.

The covered call is executed as follows

The investor holds 1,000 shares in XYZ as at 1st January 2010; the share is trading at $54. The investor has a short term neutral view on its share price for the month of January 2010. As such the investor sells (writes) 1 x (out-of- the- money) XYZ JAN $55.00 Call option for $0.70 premium.  The income the investor derives from writing the call option is 1 x 0.70 x 1000 (1,000 shares per contract) =$700 (excluding brokerage).

Three possible Scenarios will occur

• 1) XYZ will trade sideways for the month of January and at expiry closes lower than the $55 strike price. The result is the call option expires worthless, the investor keeps the premium and the investor retains a long position in the XYZ shares.
• 2) XYZ falls in value far below the strike price of the call option at $55. The result is the option expires worthless; the investor keeps the premium and retains a long position in XYZ shares.
• 3) The XYZ share price increases above the strike price of $55. The result is the call option is exercised (The investor sells 1,000 share at $55) and the upside on the share is capped at $55, plus the call options premium.

 Alternative action prior to expiry

If the investors view on the share price changes significantly prior to the call option expiring, the investor can close out (buy) the call position on the ETO market. The closing transaction thus relieves the investor of the obligation to sell their shares at the strike price of the call option (in this example $55). Prior to taking this action the investor should weigh up the profit and loss that could be realized from the option transaction against the unrealized profit or loss from holding the underlying share.

Overall, while this strategy can offer limited protection from a decline in price of the underlying share and limited profit with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned a on the written call and is obligated to sell his shares. The covered call is generally regarded as a conservative strategy because it decreases the risk of stock ownership.

Potential Risks

The covered call strategy can cause some opportunity loss when the market rallies and pushes prices above the strike prices. In the event that the market falls significantly and the investor’s portfolio value drops, although their loss is reduced by the premium income received, the investor is in a position where they cannot sell their shares to uphold their ‘covered’ status. That is, they have sold call options over these shares and need to hold the shares in the case they are called to sell the shares to the counterparty.

Another risk that would need to be considered by an investor is if the shares have large capital gains positions and then the call options are exercised, the investor may have a large capital gains tax bill to pay. That is, if the share price rises above the strike price of the sold call options then the investor will be called and will need to sell the shares. This sale of shares would incur normal capital gains tax provisions.