Covered call

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Payoffs and profits from buying stock and writing a call.
Payoffs and profits from buying stock and writing a call.

A covered call is a process in which one owns shares of a stock or other securities, and then sells (or "writes") a corresponding amount of call options. Payoffs on the stock are always the same, as with a short put option, hence the price (or premium) should always remain the same, as with a short put or naked put.

Writing a covered call generates income, in the form of a premium; however, the risk of stock ownership is not eliminated. Therefore, potential loss is equivalent to subtraction of the total amount paid as premium. Also there is potential upside down through this strategy.

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[edit] Examples

An investor has 500 shares of XYZ stock, valued at $10,000. He sells 5 calls for $1500, thus covering the decrease of same value in the XYZ stock, or we can say that only after the stock has declined by more than $1500 would the investor face net decrease on the total amount. Losses could not be prevented, but merely reduced in covered call position, even if the large amount is subtracted from the stock. This "protection" has its own disadvantage in which the investor is forced to sell his stock, if he has option like "called out" in which he buys below market price or he buys the calls back when the price of the calls rises strike price. Investors normally exercise these options before expiration date and then repurchase the stock and thus selling more calls at higher strike price and repeating same process again and again. If the stock price does not reach the strike price before expiration, the investor may simply repeat the process for the next month if he or she believes the stock will remain on a rising or neutral trend.

The investor might repeat the same process again next month if he/she believes that stock will either rise or be neutral, if before expiration stock price does not reach strike price.

call can be initiated sometimes even without ownership of underlying stock. If XYZ trades at $33 and July 35 call trades at $1, than either can purchase 100 shares of XYZ and only sell one call. For this only $3200 is required to purchase the stock rather than $3300. The premium received for the call covers the decline made by the first $100 ($1 per share) in stock price. Thus $32 stock price is break-even point of the transaction. If the results are high, then profit and lower result means loss. In the above case, the upside potential limits more than $300 ($100 for selling call and $200 for increase in share price) to 35, which amounts to almost 10% return. The investor might repurchase the stock because he cannot participate, as he is required to sell call to 35. So he sell calls at higher strike price.

Payoffs from a short put position, equivalent to that of a covered call
Payoffs from a short put position, equivalent to that of a covered call

To summarize:

Stock price
at expiration		 Net profit/loss Comparison to
simple stock purchase
$30 (200) (300)
$32 0 (100)
$33 100 0
$35 300 200
$37 300 400

[edit] Marketing

This marketing strategy is sometimes categorized as "safe" or "conservative" and even "hedging risk" as it provides high income and its flaws are well known since 1975 when Fischer Black published his theory in "Fact and Fantasy in the Use of Options. According to Reilly and Brown (2003); "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)

In recent years, the interest in covered call strategies has been enhanced by two developments according to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005): (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. After mid-2004, there was introduction of many new covered call investment products.

Even though there is limited upside and the premium is subtracted, covered calls do not suffer loss as there is complete risk of loss. Selling a naked put is similar to covered calls. Option beginners and many brokerages always categorize naked put as risky. However, a comon short put strategy allowed by many firms as a suitable transaction to beginning option traders is a cash covered put.

[edit] References

 This article or section includes a list of references or external links, but its sources remain unclear because it lacks in-text citations.
You can improve this article by introducing more precise citations.
  • Black, Fischer. “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.
  • Tan, Kopin, "Yield Boost -- Firms Market Covered-call Writing to Up Returns." Barron's, (Oct. 25, 2004).
  • 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

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