The Basics of Writing Covered Calls

06/10/2015 8:00 am EST

Focus: OPTIONS

Covered call writing is a conservative option strategy that allows option sellers to earn income while they wait for current equity holdings to appreciate in value. Here are the advantages and key risk factors to consider, says Mike Scanlin of BornToSell.com.

When used in this context, the word writing means selling and the thing that you are selling is a call option. It is covered because you own the underlying stock at the time you sell the call option. (If you didn't own the underlying stock, you would be selling an uncovered or naked option.)

But What Is a Call Option?

A call option is a tradable security that gives the buyer the right to buy stock at a certain price on or before a certain date. Similarly, the seller of a call option is obligated to sell stock at a certain price by a certain date if the buyer chooses to exercise his right.

Options almost always control 100 shares of the underlying stock. So if you are the owner of one call option, you have the right to buy 100 shares of stock at a certain price by a certain date.

For example, if you owned a January 50 call option on XYZ stock, then you have the right to pay $50/share for 100 shares of XYZ stock any time you want between today and the third Friday in January (monthly options always expire on the third Friday).

See related: How to Trade Options Expiration

If XYZ shoots to $75, you still have the right to buy 100 shares for $50 (a good deal for you). In exchange for this right, you pay the option seller some money when you buy the option.

Can You Lose When Buying Call Options?

In a word, yes. Should XYZ stock end up below $50 on expiration day, then your call option expires and you have forfeited the money you paid to the option seller. In fact, most options held to maturity expire worthless. Because of this, we believe it is better to be the seller of options than the buyer of options.

NEXT: Important Risk Factors to Consider

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What Are the Risks of Selling (Writing) Call Options?

As the seller of a call option, you are taking on the obligation of having to deliver stock to the buyer if the buyer so chooses. The risk is that the stock shoots way above your agreed-upon strike price. If it does, then you have to deliver stock at below market value to the buyer of the call option.

If you owned the stock in advance, however, this is not a problem. Your obligation is covered from the moment you entered the trade. Here's an example:

Chris owns 100 shares of ABC stock trading at $22/share. He sells one call option with a strike price of $25 and receives $100.

Let's imagine that ABC stock has increased to $30 at expiration.

Because the option is in-the-money (i.e. stock price is higher than the option strike price) the buyer of the option will exercise his right and pay Chris $25/share (the strike price) for 100 shares.

Chris is left with $2600 (the $100 from selling the option and $2500 from selling his shares) and no stock. He didn't make as much as he could have (since the stock is now at $30), but he still made a profit (since he had $2200 of stock when he started and he now has $2600 in cash).

Another risk of covered calls is that the underlying stock drops in value. It's the same risk that buy and hold investors have, with the exception that the first part of any drop is covered by the call premium you received. Because of this, covered calls are less risky than a buy and hold strategy.

Now consider the uncovered, or naked, case:

Ricky does not own the stock, but he doesn't think ABC will go over $25 by the next option expiration date, so he sells a naked call option with a strike of $25 for $100.

To his horror, ABC is at $30 on expiration day and the option buyer is exercising his right to pay $25/share for 100 shares.

Ricky now has to go into the open market and pay $30/share for stock that he has to deliver at $25/share. He will lose $500 on that 100-share trade. He did receive $100 for the option he sold, so his net loss is $400.

This is the risk of selling naked options. What if ABC had gone to $40 or $60?

Covered Call Writing Is Conservative

Writing covered calls is an income-oriented strategy. You already own the stock, so you have protected yourself from the unlimited liability situation associated with naked call writing. If the stock shoots up, you will simply hand over your shares and receive cash in exchange.

You determine the strike price in advance and set it to something for which you would be comfortable selling your stock (although the higher the strike price, the lower the call premium you will receive).

If you own shares today, then you are already taking the equity risk. Why not make those shares work for you and generate some monthly income while you wait for the stock to appreciate?

By Mike Scanlin of BornToSell.com

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