Study Notes:
This video will look at the mechanics of a covered call. This strategy marries the ownership of an underlying stock position with the sale of an equivalent amount of call options. Overall returns are largely driven by the performance of the stock, but the income from the sale of options may enhance the performance and lower the cost of ownership. However, selling or writing covered calls should not be thought of as a hedge against the long stock position, which continues to face the risk of losses in the event the share price declines.
The primary motivation of the covered call strategy is to generate income in order to enhance returns from the investment.
The covered call strategy is not appropriate for all investors, because it may lead to assignment. Should that happen, the shares are called away from the owner at the strike price. The owner may lose out on additional gains should the underlying share price keep going up.
Selling covered calls could be thought of as an exit strategy, when the investor has decided in advance that the chosen strike price represents the optimal price to take gains on a stock position. The strategy is useful to an investor who expects a steady increase in the share price over the life time of the call option written.
Let’s look at an example.
- Assume we bought 1,000 shares in ABC Corp. six months ago when its shares were trading at $45 each.
- They have now increased to $50 and the investor believes that $55 would be a good place to take profit should the stock reach that price over the next month.
A call option with 30-days to expiration is trading at $1.00. Since one contract includes an option on 100 shares, the investor sells 10 call option contracts at $1.00 each and generates $1,000 income. Writing those options has two implications. If the shares are trading above the strike price by expiration, the long call holder will most likely call the shares from the investor at the fixed price of $55 each. If the shares are trading at $60 or $70 each, the investor will miss that rally. He has granted the right to the call buyer to buy the shares from him at a fixed price of $55 each in exchange for the $1,000 premium income.
The second implication is that the breakeven facing the investor is no longer the purchase price of $45 per share. The breakeven is lowered by the value of the premium generated by writing call options. The new breakeven is $44 because the investor received $1.00 in premium (plus any commissions involved, which are not included in this example).
In summary, the covered call limits upside gains in a stock to the option strike price. The call option income acts as a cushion against losses and lowers the breakeven below the share entry price by the value of the call option premium. However, writing calls does not eliminate losses on the stock, which intheory, can still move to zero in the event the company becomes worthless.
- Maximum Gain is Strike price – stock purchase price + premium received
- Maximum Loss is Stock purchase price – premium received (and can be a substantial loss)
Choosing a Strike Price – The nearer the stock share price to the option strike price, all other things being equal, the more costly the premium of an option. A covered call writer may want to select a further out-the-money strike price, giving the stock more upside potential, but that means accepting a lower premium. The lower premium also means a reduced cushion or breakeven price for the overall strategy.
Any stock owner that might regret being assigned and losing the shares at the strike price, should consider whether the covered call strategy is right for them.
The strategy may not be appropriate for an investor expecting big returns from a stock or expecting a fast move up in its share price.
For an investor wishing to close out its short covered call position, the investor must await option expiration or buy back the call. There is no guarantee that the option will be less expensive than when it was originally sold. That means that the investor might be required to actively manage the position if the option has to be repurchased should the investor want to remain invested.
Another potential disadvantage is that investors can end up holding their position in the underlying stock longer than they would otherwise like as it “covers” the investor should the option be assigned to them.
If the investor sells the stock position prior to closing the short call position, the option may be
uncovered or “naked”, which could lead to unlimited losses on the uncovered portion of the option position as the investor would have to deliver the stock to the option buyer at the strike price while obtaining the stock at an unknown price in the market. For this reason, uncovered option writing is very risky and not suitable for all investors.
In the earlier example, we assumed that the investor previously bought stock and had watched its price rise. Another variety of covered call is the buy/write strategy, which simply means that the stock and call option positions are taken simultaneously. Such positioning may involve strike prices relatively close to the initial purchase price of the stock. It may alternatively involve a specific expiration period for the option in order to give the anticipated upside potential sufficient time to play out. However, the written option may primarily act as a way to lower the purchase price of the stock.
In-the-money calls are unlikely to be exercised until just prior to expiration. The rare exception is the day before the shares go ex-dividend. By exercising then, the call owner deprives the shareholder of the dividend.
Finally, the covered call strategy may be repeated over and over in order to generate income and enhance the overall performance of a portfolio. The only caveat is that come each expiration, the shares have not been assigned. Therefore, the stock price must have been below the strike price each time.
If you own stock and want to consider writing covered calls, you can review available call option prices by loading the ticker in to the Order Panel in Mosaic and selecting the Option Chains menu from the dropdown menu.
Alternatively, clients may use the Options Write/Rollover tool to manage the writing process. You can find this under the Advanced Tools menu and then select Write Options. The tool enables investors to select an acceptable expiration date and appropriate strike price to create covered calls against stocks held in their portfolio.
In order to create a buy/write combination in TWS, enter the underlying ticker symbol and select Combinations and then Option Combos from the expand menu. On the Strategy tab, select from the Strategy dropdown menu the Buy Write combo. Choose an expiration date from the Last Trading day dropdown menu. Then choose a suitable strike price and close the Combo Selection tool by clicking OK at the bottom of the window. The strategy has now been added to your Mosaic watchlist. In TWS the buy write is priced as the share price minus the premium received. Clicking on the Buy button will generate an order to buy shares and sell a call option. Enter the price, quantity and time in force.
Before submitting your order, you may check the performance profile by clicking the Advanced expand button to the right in the Order Entry panel. On the Order Preview window, check the Performance Profile box to see the Performance Graph. You can see the P&L plot through expiration in the chart as well as the associated Greek values in the table beneath. The table displays those values for a given change in the value of the share price both up and down on the selected date. Change the date using the calendar drop down menu to the right either above the table or above the plot.
The plot displays two lines. The solid line depicts the at-expiration P&L on the right axis associated with any share price shown on the lower axis. The dotted line shows the same value but for the date chosen from the calendar dropdown menu.
The solid 45-degree line inflects at the strike price. To the right of the strike price it runs horizontally to show maximum profits at and above the strike price. To the left of the strike price P&L erodes and disappears altogether at the breakeven point cutting the horizontal zero axis. To the left of the breakeven, the losses stack up dollar for dollar should the share price continue to decline.
The covered call strategy can be created on an ongoing basis, while a buy-write is strictly a simultaneous transaction. Investors could write long-dated call options against stocks held in their portfolios or could run an active strategy of writing calls week-after-week and watching them expire. At the heart of the strategy is assignment. If the investor really does not want to lose the shares, the strategy may not be appropriate for the investor.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Margin Trading
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.
For additional information regarding margin loan rates, see ibkr.com/interest
Disclosure: Options Trading
Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.
