Options for Your Investments: Covered Calls

08/15/2012 1:30 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Over the past several years, there has been a virtual revolution among investors. Individuals have been taking matters into their own hands. Changes in the investment industry, including lower commissions, accessible online brokers, greater liquidity, and better trading tools have given rise to the “self-directed trader.” These trail-blazing investors have a great number of resources at their disposal. They have options.

Options are investment vehicles that have been around for centuries that can help investors control risk. One of the most useful option strategies for traditional stock investors is the covered-call strategy. The covered call is a conservative options strategy used by professional and individual investors alike. Individual investors can benefit from the covered call like the professionals if they take some time to learn the nuances of this important strategy.

Covered Calls: What They Are and How They Work

A covered call can be used to generate additional income from a stock position. A covered call position is established when an investor owns shares of a stock and, at the same time, sells calls. Before moving ahead, let’s examine what a call option is.

Call Options

Call options are contracts that give the buyer of the option the right, but not the obligation, to buy 100 shares of the stated underlying stock at a specific price (called the “strike price”) anytime before the option contract expires.

Investors may take a position as either a buyer or a seller of a call option. Selling options (as a short position) is a very common options technique and is the basis of the covered call strategy to be discussed. The seller of a call option has the obligation to sell 100 shares of stock to the buyer of the call option if the buyer chooses to exercise the right guaranteed within the contract.

Covering Call Risk

The problem with selling a call is that unless it is “covered” the risks can be great. For example, imagine an investor sells one November 50 call on a stock. Now imagine the stock rises to $80 a share. The seller of the call would be obligated to sell 100 shares of stock at the strike price of $50 while the stock is at $80. The investor would, therefore, have to buy stock on the market at $80 only to sell it at $50 to the call owner exercising the right inherent in the contract he owns. That’s a $30-a-share loss. The conservative approach to selling calls is to sell them covered.

A call is said to be covered if the seller of the call option owns the underlying shares and is able to deliver the shares if the option is exercised, without buying them in the open market. There are several advantages to this strategy.

When a call option is sold, premium is collected. This cash premium is paid to the seller from the buyer for the right to buy the shares of stock at predetermined (strike) price in the future. The premium is the seller’s money to keep regardless of whether the call option is exercised.

Creating a Covered Call

As previously noted a covered call involves buying or already owning stock, and additionally selling a call to create a position consisting of two components: the long stock and the short call. As an example let’s say an investor bought 100 shares of XYZ stock for $40 a share and sold a call option with a strike price of $45 for a premium of 3.00.

What happens between the date of the trade and the expiration date of the option determines the profit or loss on the position. As long as the stock is trading below the option’s strike price ($45 a share) at expiration, the option will expire (and, therefore, cease to exist) and the investor will keep the premium of 3.00. Why? Because the owner of the call would not want to exercise the call, thereby buying stock at $45, if he could buy the stock at a lower price in the market.

If the stock rises above the strike price, the investor is at risk of having the stock “called away.” If the stock is called away, the covered call investor will fulfill the obligation acquired when the call was sold, and therefore sell the stock he owns at $45 a share (the strike price). This would result in a profit, but the maximum profit is capped because stock must be sold at $45 a share, even if it is trading higher.

If the stock price drops, the call option that was sold can provide some downside protection to lessen the loss suffered. This protection is capped at the difference between price the stock was purchased and the premium collected. In the example above the protection provided by the covered call would be 3.00. This protection effectively lowers the cost basis of the stock to $37 ($40 [the stock’s actual purchase price] minus $3 [the premium]). If the stock finishes above $37 at expiration, the strategy is a winner. If the stock is below $37 at expiration, the covered call would have lost money.

Investment Criteria

Let’s look at the criteria an investor would need to consider to trade a covered call:
 
Typically when looking for a covered call candidate, an investor will pick a stock with a neutral to slightly bullish outlook as a covered call candidate. Ideal candidates are less volatile stocks that have been slowly rising for several months. Remember, the goal of a covered call is to make money on the underlying stock as well as the sold call’s premium, so it’s advantageous to find a stock that appears likely to gain some value.

The best-case scenario for a covered call is achieved when the stock moves right to the strike price at expiration. In this scenario, the stock has moved up to its maximum potential value without being called away and the sold call expires, representing maximum profit (remember, the seller keeps the premium). If the stock moves above the strike price at expiration, the person who bought the call will exercise the right and force the covered call investor to sell him the stock at the strike price. This isn’t necessarily an unfavorable outcome because maximum profit was achieved. But, of course, now the investor no longer owns the stock. In fact, this can be a beneficial “exit strategy” if the investor’s objective is to sell the stock at the price coinciding with the strike price of the option.

This brings up an important point. If an investor is extremely bullish on a stock, a covered call is not a practical strategy. Remember, the covered call limits upside potential. If the stock rises above the strike price, the investor misses out on continued profits above and beyond the strike. If the investor thinks the stock is more than slightly bullish, it might be better to just buy the stock alone, with no call, so the reward is not limited. The same goes for a volatile stock like Apple Inc. (AAPL) or Google Inc. (GOOG). Those types of stocks can go up, but also down, quickly. This, of course, can lead to a losing covered call position if the share value drops beyond the limited protection provided by the premium.

Selecting the Strike Price and Expiration Month

Picking the strike price and the expiration month are two very important decisions an investor needs to make. Selecting the right call strike is important because the call strike essentially controls the level of protection provided and how limited the reward may be. The lower the strike sold, the greater the premium received, thus the greater protection offered. The higher the strike, the lower the premium, but the less profit potential is limited. Strike selection is a delicate art.

Deciding the expiration month is, likewise, a trade-off. The further out to expiration, the more premium the sold call will generate but the longer the position will have to be held to reach maximum profit. The shorter time will generate less of a premium but the call expires sooner eliminating the obligation. Ultimately, the trader must forecast the price within a timeframe and then select the call strike and month accordingly.

An investor must also decide if it matters if the underlying stock is called away. Sometimes people have long-term objectives for the stock and do not want to sell it. If this is the case then call options with extremely high strikes may be chosen to try to ensure the stock is not called away. With the extra “wiggle room” to the upside that is provided by a higher-strike call, the trader may be able to “buy back” the call, closing the call’s obligation, before the stock goes above the strike price to ensure the option can not be exercised.

Conclusion

There are multiple ways in which covered calls can benefit an investor. First, it can increase the return on a neutral-to-moderately bullish stock. Second, it offers some downside protection if the stock decreases in value and third, it lowers the overall cost basis when buying shares of stock. Because options have risk, an investor must understand the risks involved and study the many different choices of strategies including the pros and cons of each before making a decision.

 Dan Passarelli is the author of Trading Option Greeks and The Market Taker’s Edge. He is also the founder and CEO of Market Taker Mentoring, Inc., an education resource for option traders. Dan can be contacted through his Web site, MaketTaker.com.

Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corp., One North Wacker Drive, Suite 500, Chicago, IL 60606. The strategies described in this article are intended to be educational and/or informative in nature. No statement is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.

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