A covered call is an investment strategy in which you own a specific stock and then "write" a call option against that stock (and collect some cash immediately). When you do this you're increasing the chance that you'll make money on the stock but you give up some of the upside potential.
- Everybody knows that when you buy a stock, if the stock price goes up
you make money. And if it goes down, you lose money.
- But when you write a covered call, you get the option premium
immediately and pocket that cash*.
- If the price of the stock goes up, your upside is capped. That’s
because when you “write” a call option, you’re giving someone else the
right to buy or “call away” your stock at the strike price.
- On the other hand, if the price of the stock goes down, your losses are
at least partially offset by what you made when you wrote the call*.
Picking a Call Option
When you evaluate the many alternative scenarios you can use to write a covered call, you may be overwhelmed by the magnitude of possibilities. You can write calls in-the-money, at-the-money, or out-of-the-money.
| TYPE |
RISK |
PROS |
CONS |
|
In-the-Money Covered Call
|
Safest covered call approach
|
Chance of losing money is lowest (most conservative)
|
Your shares have a highest chance of getting called away.
Less "time value" premium means your upside is lower.
|
|
At-the-Money Covered Call
|
Riskier covered call approach
|
Highest "time value" premium that you get to pocket.
|
Good chance your shares will be called away. Less downside protection
|
|
Out-of-the-Money Covered Call
|
Riskiest covered call approach
|
Less chance of having the underlying shares called away.
Use this strategy if you want to keep the shares. If the price of the underlying stock goes up, you get a piece of that premium.
|
You collect less options premium up front. So you have least downside protection.
|
You will find the greatest time-value portion of the premium with calls written at-the-money. But if you write calls at-the-money or out-of-the-money you will have less downside protection, even though the potential returns may be higher.
Below is an options chain example for a stock where the last trade was $17.82.
Last trade = $17.80 (expiration 31-days out)
|
STRIKE
|
BID
|
ASK
|
MIDPOINT
|
TIME VALUE*
|
INTRINSIC VALUE*
|
DELTA
|
|
12.50
|
5.40
|
5.70
|
5.55
|
0.25
|
5.30
|
.962
|
|
15.00
|
3.40
|
3.60
|
3.50
|
0.70
|
2.80
|
.821
|
|
17.50
|
1.80
|
1.95
|
1.85
|
1.55
|
0.30
|
.577
|
|
20.00
|
0.85
|
0.95
|
0.90
|
0.90
|
0.00
|
.333
|
*Calculated using mid-point between the bid and the ask
The most you can expect to gain from writing a covered call is the time value of the premium you write (less the commission paid). For example, by selling the covered call at the $17.50 strike, you take in $1.85 in premium —shown in the example above as the mid-point between the bid and the ask prices. Because the option you sold is slightly in the money, you have to expect it will be exercised and the stock will be called away at $17.50 per share on, or before, options expiration. Adding everything together, your total expected revenue from the trade will be $19.35 per share —which is $1.55 higher than the last trade price of $17.80. The time value for this option is $1.55.
With the possibility of a dramatic drop in the price of the stock, "downside protection" plays a role in your strategy. You need to understand that you are not certain to make money on your covered call strategy, because if the stock goes down below the strike price of the option you sold, you will continue to own the shares. No one will exercise the option to buy the shares at the strike price because they can be bought for less money on the open market. That means if the price continues to fall, you will take the loss.
In the event that the price of the stock goes down, your downside protection in the example above is $1.85 below the current stock price. That's what you collected in premium. In other words, the stock would have to fall $1.85
—
or 10%
—
before you would start to lose money on the position.
Assuming the stock does not fall below $17.50, and your shares are called away, or sold, your expected profit will be $155. That is the time-value amount ($1.55) of the option premium you sold, multiplied times one hundred. (Remember, a single option contract equals an option to buy, or sell, 100 shares of stock, so always multiply option numbers times 100.) In percentage terms, in this example, your return on investment would be 8.7% over the next 31 days (less commission paid).
As a comparison, let's say you did the same strategy using the 12.50 strike. In that instance, you would write the option on a 12.50 call and take in total premium of $5.55 and expect your shares to be called away at $12.50. Your time value, in this case, is only $0.25, or $25. Your expected percentage return in this example would be 1.3% over the next 31 days (less commission paid).
So here is a comparison of the two positions:
| STRIKE PRICE |
TIME VALUE OF OPTION |
PROJECTED RETURN |
DELTA |
|
17.50
|
$0.68
|
8.7%
|
.58
|
12.50
|
$0.23
|
1.3%
|
.96
|
In this comparison, delta is used as a rough estimate of the probability of return. It indicates an 58% probability of the position being profitable for a $17.50 covered call. The decision the covered call writer has to make then, assuming they want to write an option in-the-money, is whether they want to have a 58% probability of a 8.7% return, or a 96% probability of a 1.3% return over the next 31 days.
Keep in mind this is only one example and that while Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
How to Finish
With a covered call, if the option is in the money at expiration, it will be called away and the shares of the underlying stock will be taken from your account. If you don't want to deliver the shares (e.g., if you would incur substantial capital gains), then you can "buy to close" an identical call.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.