Analyzing the Covered Write

Last time we talked about what it means to write a covered call, explained the difference between intrinsic and time value, and discussed the reasons for writing a covered call. In case you missed it, here's a quick review:

• When you write a covered call you are selling a call option contract against a stock you already own.
  
• If you exercised an option right after buying it the intrinsic value is all you would receive.
  
• The time value of an option is the portion of the value that is not intrinsic value.
  
• Covered calls are generally written for income, to hedge a position, or because you think the options are over-priced.
  

Learning to Speak Optionese: Analyzing the Covered Write

When it comes right down to it, we're all in the market to make money. Not just you and me, but others who are smarter, and perhaps faster than us. That is why it is important for us to thoroughly analyze a position before entering into it; we don't want to get screwed by the big guys! It's important to play smart, because stupid mistakes can cost a lot of money.

Considering the Risks

To better understand the risks of writing a covered call we're going to look at writing covered calls against BAC. I have created a chart to break down my analysis for you.

BAC Calls
BAC's Current Price	Strike Price	Price
$15.05	$14.00	$1.23
	$15.00	$0.54
	$16.00	$0.18
Intrinsic Value	Time Value	Breakeven Downside
$1.05	$0.18	$13.82
$0.05	$0.49	$14.51
$0.00	$0.18	$14.87
Breakeven Upside	Return as a percentage	% Decline to Break Even
$15.23	1.20%	8.17%
$15.54	3.26%	3.59%
$16.18	1.20%	1.20%

Alright, so you might be wondering what this all means, let's break it down:

In this particular situation we are going to write calls against BAC. However, we can't decide exactly which calls to write! We want a good mix of risk protection and return, so we decide to consider the risks.

Let's take a look at the comparison chart. It breaks down a number of things. Under the 'call' header are the three strike prices we are considering, 14, 15, and 16. Both the 14's and 15's have a bit of intrinsic value, the 16's have none. The more intrinsic value an option has, the safer it is to sell against a stock position, and the more likely that the stock gets called away from you when the option expires.

Why is it safer to write a covered call that has intrinsic value? As you can see on the chart, the breakeven downside for the 14 is the farthest away from the current stock price. It also possesses the greatest amount of intrinsic value. The reason this call is safer to sell? It is safer to sell because you are selling some of the value of the stock with it. Since the striking price is 14, the buyer can immediately exercise this option and receive 1.05. Because of this, they have to pay extra for the option. This extra money is nice, because if the stock declines to or a tad below the strike price you still break even! Unfortunately, for the same reason, the actual premium you receive is much smaller, a mere .18 of time value! If the stock moves a little over 1% upwards, you're actually losing out on money. With great downside protection, comes limited reward.

So selling the 14 sounds good, but damn it, BAC is going to the moon! Maybe not the moon, but at least to 16.00! What should you do then? Sell the 16's, of course! That doesn't seem right, you barely get any premium for the 16's, the time value is only .18, I'd get that for the 14! You're right, but if the stock moves to 16 and you had sold the 14 when BAC was trading at its current levels you wouldn't get any of the gains from the stock, you would have given them all up by selling the 14 call! However, if you sold the 16, you'd get the .18 in premium and .95 of appreciation. That's a decent percentage return. The downside protection is obviously limited, but that's why this sell is for the bulls. Though, if you really think BAC is going to the moon, perhaps it would be better to simply hold the stock.

Alright, it seems there are higher risk covered writes and very low risk writes… but what if I want something in between? I'm not particularly bullish, nor am I bearish, at least for now. I believe in the fundamentals of the company in the long run, and I'm going to hold their stock until I retire, but there isn't anything exciting going on to move the stock in the near future! In a case like this, you should look at selling the 15, which is closes to the stock's current price. Selling this particular call offers the best mix of risk and reward on both sides. Because it is so close to the stock's current price it is more expensive, if the stock moves upward it will appreciate rapidly. If it moves downward it'll lose value in a jiffy. Luckily, with a 3.5% buffer on both sides, stock movement won't upset you too much! Generally speaking, selling the calls closest to the current price of the stock offers the best mix of risk and reward.

Let's Review

The options with no intrinsic value (also known as out-of the money options, because they have no intrinsic value) are very attractive to sell, because they will likely expire worthless. However, the return as a percentage is somewhat low. This is somewhat deceiving. If the stock does increase in value and surpasses the strike price, or remains just under it, you will have made even a greater percentage of return, as you will also receive the capital gains up to the strike price! The downside of this is that your downside is not well protected, and if the stock ends up performing poorly into expiration you may quickly acquire a loss. For this reason, selling call options with strike prices that are further away from the stock's current price is considered a more bullish covered write.

The options with strikes closest to the stock's current value (also known as at the money options, because they are close to having intrinsic value) offer the best mix of both risk and reward. If you are neutral on the stock overall, those are the calls you should be selling!

For the more conservative or cautious investor, it is best to sell options with a bit of intrinsic value (known as in the money options). If you are bearish on a stock or simply want a better chance of going into expiration with a profit then this sort of covered write is worth considering.

Selling calls at different strike prices create positions with better downside protection, more reward, or a mix of both!

Covered calls offer an attractive opportunity for any investor or trader looking for a manageable amount of risk exposure. With such a great mix of risk and reward, even a rookie can properly execute this strategy (although he should practice in a virtual account first!). On top of this, the covered write is a safe way to take advantage of 'excited' options and time decay. With a little research, and proper analysis, you can make decent percentage gains or generate income by selling calls against stocks you already own!

Until next time,

Spencer Sundahl

p.s. To simulate how writing a covered call will work out over time, and to create profit and loss graphs, check out these analytical tools:

Strategy Screener:
http://www.888optionsnet.com/investigator_2/wi_strategyExplorer.asp
Click on the covered call strategy

Position Simulator:Position Simulator: http://www.888optionsnet.com/investigator_2/wi_positionSimulator.asp Enter what stock and option positions you would like to simulate, and see how the position reacts to movements in the stock and as time passes.