Covered Calls

A trader can create a covered call by selling the call options on a security already owned by him. For example, Trader Z owns 1,000 shares of security ABC and then proceeds to sell 10 calls of the same security. Such transaction creates covered call position. Another similar position is called ‘Buy-Write’. Under this strategy, a trader buys the security and writes the call position simultaneously. This synthetic position has the same pay-off as that of writing a put option. This position is called ‘Covered Call’ as the ownership of underlying security acts as a cover for the risk taken on by writing of the call. In case the buyer of the call decides to exercise the option, the trader can fulfill the obligation through the stock already owned.

Covered call helps a trader to control risk on writing options. However, this position does not eliminate the inherent risk of owning a security. The trader will still suffer the loss if the holding loses its market value. However, Covered call can lead to some income if the stock price increases or remain the same. The income is generated in the form of premium received on writing the call. However, if the stock price decreases, then trader may suffer net loss. At the equilibrium position, covered call can give the same payoff as that of a written put strategy. The premium for a covered call is same as that of a naked put or short put.

Covered call provides protection against unlimited loss potential of a written call option. However, it has its downside too. This strategy can reduce profits as well. Trader Z owns 500 shares of ABC valued at $5,000. Trader Z further writes 5 calls of the stock at $500. The strategy ensures that the trader does not suffer any loss as long as the stock price declines by only $1 per share. The trader starts to suffer the loss only when the stock price hits below $9 apiece. In such cases, the option will expire worthless as the buyer of the calls would be able to buy the stock at cheaper price in the open market. Hypothetically, if share price decreases to $8, then the trader’s loss would be at $1000-$500 i.e. $500.

However, if the stock price increase to say $12, the buyer would like to exercise the option then net payoff from the position would be equal to the premium obtained in the beginning. The trader will have to forego any notional profit accruing on account of the rise in share price. If the spot price is not on the strike price before expiration then the trader may repeat the entire process, provided the outlook suggests that the stock price would remain neutral or may fall.

Another scenario involves writing the call, even though the writer does not own the stock. However, under this strategy the stock is bought simultaneously with the writing of the call. This strategy is known as ‘Buy Write’. Let’s assume that stock ABC is currently trading at $13 and its $15 call is priced at $1. Z purchases 100 shares at $13 for $1300 and immediately writes one call and gets $100 in premium. The net cost of the stock decreases to $1200 for the trader. Thus the breakeven point for this strategy is now $12 per share. The maximum gain that the investor can make on this transaction is $300, which is the aggregate of the run up in stock price plus the premium obtained for writing the call. This point occurs if the stock price goes above $15 per share. In case the stock price hovers between $12 and $15 the call would expire worthless but the trader can choose to sell the shares in open market to pocket the capital gain. The trader will suffer loss if the stock price ends below $12 per share.

In case the trader writer sells call option without actually owning the stock, the strategy is called naked call option. Naked call writing entails unlimited loss. If the buyer of the call option decides to exercise the option, then the writer is under obligation to sell the stock at strike price.

Covered call option is advised in case where the investor is interested in generating moderate income without excessive risk. This strategy can help the investor make some money if the market is in range bound condition. The investor can buy and hold the stock while making a little money off covered call strategy. Under this strategy, the writer should sell and out of the money option. While this strategy does not offer the kind of gains offered by other option strategies, but covered call provides low risk strategy. This strategy can also help novice option traders.

Covered Call option is considered to be conservative or safe option. The strategy can also be used for hedging purpose. The strategy was made popular by Fischer and Black through their publication “Fact and Fantasy in the Use of Options”. Ibboston Associates’ case study on buy write strategy has also helped making this strategy popular. Chicago Board Options Exchange introduced CBOE S&P 500 BuyWrite Index for the purpose of providing benchmark for covered call options. The move helped to make this strategy appealing for masses. Reilly and Brown commented that the investor should be fairly certain about the stock price remaining in the range bound level for this strategy to succeed.