Covered call
From Wikipedia, the free encyclopedia
A covered call is a combination of owning shares of a stock or other securities and selling (or writing) a call option on those shares in corresponding amounts. It has essentially the same payoffs as a short put option on the stock, and thus should have essentially the same price (or premium) as that of a short put.
A covered call strategy provides income that helps cushion, but does not eliminate, the downside risk of stock ownership. As a tradeoff for providing premium income, the strategy limits the potential upside return. Unfortunately, this strategy sometimes is marketed as being "safe" or "conservative," even though the flaws in this marketing logic have been well known, at least since Fischer Black published “Fact and Fantasy in the Use of Options" in 1975. Reilly and Brown (2003) state "to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels." (p. 995)
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[edit] Examples
If a trader owns 500 shares of XYZ stock worth $10,000 and sells 5 calls worth $1500 then the first $1500 of decrease in the value of XYZ stock is covered. Meaning the investor does not incur a net decrease in value until after the stock declines by more than $1500. However, the covered call position does not prevent losses should the stock decline by a large amount. This "protection" is offset by the disadvantage of being forced to sell the stock (if called) at below market price or buying back the calls should the price rise above the calls strike price.
Sometimes a covered call is initiated without already owning the underlying stock. If XYZ is trading at 33, and the July 35 call is trading at $1, then one can simultaneously purchase 100 shares of XYZ and sell one call. This requires a net outlay of $3200 compared to $3300 to just purchase the stock. The first $100 ($1 per share) of decline in the stock price is covered by the premium received for the call. Thus the break even point of this transaction is a stock price of $32. Anything higher results in a profit. Anything lower results in a loss. The upside potential for the above is limited to a maximum of $300 (the $100 received for selling the call and $200 for the increase in the share price to 35) a return of almost 10%. The investor does not participate in any further upside as the call requires the investor to sell at 35.
[edit] Marketing
The marketing of a covered call strategy as a safe investment involves a change in comparisons: if the stock price decreases the covered call writer will profit - compared to someone who only owned the stock. If the stock price increases the call writer will profit - compared to someone who didn't own the stock.
Another term for the covered call strategy is a "buy-write" strategy, in that the investor buys stocks and writes call options against the stock position.
According to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005), two developments have enhanced the interest in covered call strategies in recent years: (1) in 2002 the Chicago Board Options Exchange introduced the first major benchmark index for covered call strategies, the CBOE S&P 500 BuyWrite Index (ticker BXM), and (2) in 2004 the Ibbotson Associatesconsulting firm published a case study on buy-write strategies. Many new covered call investment products have been introduced since mid-2004.
[edit] Examples of Covered Call Investment Products
[edit] References
- Fischer Black, “Fact and Fantasy in the Use of Options.” Financial Analysts Journal 31, (July/August 1975), pp. 36-41, 61-72 .
- Blake, R. "Investors Are Dusting Off an Old Strategy, Options Overlay; When It Works, It Offers Both Yield Enhancement and Risk Management." Institutional Investor, (Sept. 2002), pp. 173 - 174.
- Crawford, Gregory. “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005).
- Feldman, Barry and Dhuv Roy. "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index." The Journal of Investing, (Summer 2005).
- Ferry, John. "An Array of Options - A Buy-write Strategy Can Add Some Octane to Portfolios When the Markets Lack Direction." Worth Magazine, (April 2005), pp. 102 - 104.
- Hadi, Mohammed. "Buy-Write Strategy Could Help in Sideways Market." Wall Street Journal. (April 29, 2006) pg. B5.
- Hill, Joanne, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens. "Finding Alpha via Covered Index Writing." Financial Analysts Journal. (Sept.-Oct. 2006). pp. 29-46.
- Moran, Matthew. “Risk-adjusted Performance for Derivatives-based Indexes – Tools to Help Stabilize Returns.” The Journal of Indexes. (Fourth Quarter, 2002) pp. 34 – 40.
- Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management, 7th edition, Thompson Southwestern, 2003, pp. 994-5.
- Schneeweis, Thomas, and Richard Spurgin. "The Benefits of Index Option-Based Strategies for Institutional Portfolios" The Journal of Alternative Investments, (Spring 2001), pp. 44 - 52.
- Tan, Kopin, "Yield Boost -- Firms Market Covered-call Writing to Up Returns." Barron's, (Oct. 25, 2004).
- Tergesen, Anne. "Taking Cover with Covered Calls." Business Week, (May 21, 2001), pp. 132.
- Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index" The Journal of Derivatives, (Winter 2002), pp. 35 - 42.
- James W. Yates, Jr. and Robert W. Kopprasch, Jr. "Writing Covered Call Options: Profits and Risks," Journal of Portfolio Management 7 (Fall 1980)
[edit] See also
[edit] External links
- Covered Call
- Options Toolbox
- Yahoo! Covered Calls
- Covered Call Screener
- Covered Calls Worksheet
- CBOE BuyWrite Indexes
- Australian Exchange -- S&P/ASX Buy-Write Index
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