Learning to Speak Optionese:
Writing Covered Calls for Income
Today we’re going to discuss writing a covered call. It is considered the most basic option strategy where one writes a call option against a long stock position.
Writing Covered Calls for Income
Today we’re going to discuss writing a covered call. It is considered the most basic option strategy where one writes a call option against a long stock position.
Let’s go back to our previous example about the enchanted necklace. As you may remember, the owner of the necklace struck a deal with you (the potential buyer) that was very similar to a call option contract. It gave you the right, but not the obligation, to buy the necklace at a certain price for a specified period of time. For a small premium, you gained all the appreciation potential of the necklace, and took on a very limited risk. If the necklace turns out to be worthless, you only out the premium you paid for the call! So you might be wondering, why would anyone in the world write a covered call?
Considering the current market condition and the volatility that has persisted in the markets in the recent past, it may seem unwise to be writing covered calls. However, despite the recent turmoil, writing covered calls is still a very attractive and effective strategy.
So why write a covered call?
Why does the owner of the necklace sell you a call? It’s simply a matter of attrition. The owner knows it is likely the call will go unexercised and he will retain ownership over the necklace as well as the premium you have paid. As I mentioned previously, options are wasting assets, meaning, they decay with time. However, along with time value, options also carry intrinsic value. This may not seem pertinent to the question at hand, but you will see how time value and intrinsic value affect the price of an option make some covered calls very worth selling.
Let’s say stock XYZ is trading at 45 dollars. XYZ is a relatively boring stock, and has been trading in the 40’s for many months. Market participants agree it is likely to stay in that range until at least the next earnings announcement, which is two months away. Because no one is making any big bets on a large increase in the price of XYZ, call options are moderately priced. One day you acquire 1000 shares of XYZ for 43.00 dollars a share.
Out of curiosity you look at XYZ option prices for the closest expiration date. You see that calls expiring in a month with a 40.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 40.00 a share) are trading for 4.00. Also expiring in a month are XYZ calls with a 45.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 45.00 a share), those options are trading for .80. At first glance the XYZ 45.00 calls may seem like the best deal, for .80 you get a great deal of profit potential. However, if, in a month, XYZ has not moved over 45.00 the call is worthless. That is, the entire .80 you paid for the option was time value, or premium paid for the potential appreciation of a stock over the life of the option. The stock would have to move over 45.80 before you had anything to show for it, (strike price + premium paid = breakeven point).
On the other hand, the XYZ 40.00 calls have an intrinsic value of 3.00 at the time of purchase, meaning, if you exercised the call (when you exercise a contract you buy, or sell in the case of a put, 100 shares of the underlying stock at the specified strike price) you would instantly realize a profit of 3.00 a share.
To find the time value you simply subtract the intrinsic value from the premium you paid (4.00 – 3.00 = 1.00), so the intrinsic value of the option is 1.00. If XYZ moves anywhere over 44 (strike price + premium paid = breakeven point), then you make a profit on the option. If it is anywhere above 40.00 at the time of expiration then your option still has value. I will cover more about how to price an option later this week, but for now knowing the difference between intrinsic and time value will get us through.
Out of curiosity you look at XYZ option prices for the closest expiration date. You see that calls expiring in a month with a 40.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 40.00 a share) are trading for 4.00. Also expiring in a month are XYZ calls with a 45.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 45.00 a share), those options are trading for .80. At first glance the XYZ 45.00 calls may seem like the best deal, for .80 you get a great deal of profit potential. However, if, in a month, XYZ has not moved over 45.00 the call is worthless. That is, the entire .80 you paid for the option was time value, or premium paid for the potential appreciation of a stock over the life of the option. The stock would have to move over 45.80 before you had anything to show for it, (strike price + premium paid = breakeven point).
On the other hand, the XYZ 40.00 calls have an intrinsic value of 3.00 at the time of purchase, meaning, if you exercised the call (when you exercise a contract you buy, or sell in the case of a put, 100 shares of the underlying stock at the specified strike price) you would instantly realize a profit of 3.00 a share.
To find the time value you simply subtract the intrinsic value from the premium you paid (4.00 – 3.00 = 1.00), so the intrinsic value of the option is 1.00. If XYZ moves anywhere over 44 (strike price + premium paid = breakeven point), then you make a profit on the option. If it is anywhere above 40.00 at the time of expiration then your option still has value. I will cover more about how to price an option later this week, but for now knowing the difference between intrinsic and time value will get us through.
Perhaps, you’re catching on, but if not, I will explain. Let’s say you own stock XYZ, it pays a decent dividend, but it rarely moves. You look and see that options without any intrinsic value are trading at a decent premium and would require XYZ to move over 5% in a month to be worth anything at expiration. That sounds pretty attractive doesn’t it? If XYZ does move the 5%, your stock will get called away from you (the purchaser of the call will ‘call’ your stock out of your account and into his own). You’ll get to keep the premium, and the 5% in capital gains. Let’s say XYZ declines a bit instead. The premium you gained from selling the calls will protect your downside (stock price – premium = break even for a call seller).
Selling covered calls may not be the most exciting investment strategy, but it is considered the safest options strategy, and has a good track record of producing returns. Also, when the market seems to be overvalued selling covered calls can be a great way to hedge (protect against) a potential decline in the share price of a stock.
Selling covered calls may not be the most exciting investment strategy, but it is considered the safest options strategy, and has a good track record of producing returns. Also, when the market seems to be overvalued selling covered calls can be a great way to hedge (protect against) a potential decline in the share price of a stock.
Next, I will…
- Delve further into the strategies behind writing covered calls
- Show you a covered call profit/loss graph and explain how to make one
- Show you three attractive stocks to write covered calls against, and explain the risks and rewards involved in each.
- Set you up with a virtual account where you can experiment with writing covered calls and the other options strategies I will be explaining next week!
Until Tomorrow,
Spencer Sundahl
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