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The covered call is a strategy in which an investor writes a call option contract
while at the same time owning an equivalent number of shares of the underlying stock.
If this stock is purchased simultaneously with writing the call contract, the strategy is
commonly referred to as a "buy-write." If the shares are already held from a previous purchase,
it is commonly referred to an "overwrite." In either case, the stock is generally held
in the same brokerage account from which the investor writes the call, and fully collateralizes,
or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining
the flexibility of listed options with stock ownership.
MARKET OPINION: Neutral to bullish on the underlying stock.
Though the covered call can be utilized in any market condition, it is most often
employed when the investor, while bullish on the underlying stock, feels that its
market value will experience little range over the lifetime of the call contract. The investor
desires to either generate additional income (over dividends) from shares of the underlying
stock, and/or provide a limited amount of protection against a decline in underlying
stock value.
While this strategy can offer limited protection from a decline in price of
the underlying stock and limited profit participation with an increase in stock price, it generates
income because the investor keeps the premium received from writing the call. At the
same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends
and voting rights, unless he is assigned an exercise notice on the written call and is obligated
to sell his shares. The covered call is widely regarded as a conservative strategy because
it decreases the risk of stock ownership.
Profit Potential: Limited
Loss Potential: Substantial
Upside Profit at Expiration If Assigned:
Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price
Upside Profit at Expiration If Not Assigned:
Any Gains in Stock Value + Premium Received
Maximum profit will occur if the price of the underlying stock you own is at or
above the call option's strike price, either at its expiration or when you might be assigned
an exercise notice for the call before it expires. The risk of real financial loss with this
strategy comes from the shares of stock held by the investor. This loss can become substantial
if the stock price continues to decline in price as the written call expires. At the call's
expiration, loss can be calculated as the original purchase price of the stock less its current
market price, less the premium received from initial sale of the call. Any loss accrued from
a decline in stock price is offset by the premium you received from the initial sale of the call option.
As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is
always possible. An investor holding shares with a low cost basis should
consult his tax advisor about the tax ramifications of writing calls on such shares.
BEP:
Stock Purchase Price - Premium Received
Volatility Increases: Negative Effect
Volatility Decreases: Positive Effect
Any effect of volatility on the option's price is on the time value portion
of the option's premium.
Passage of Time: Positive Effect
With the passage of time, the time value portion of the option's premium generally
decreases - a positive effect for an investor with a short option position.
If the investor's opinion on the underlying stock changes significantly before
the written call expires, whether more bullish or more bearish, the investor can make a
closing purchase transaction of the call in the marketplace. This would close out the written
call contract, relieving the investor of an obligation to sell his stock at the call's
strike price. Before taking this action, the investor should weigh any realized profit or loss from
the written call's purchase against any unrealized profit or loss from holding shares of the underlying
stock. If the written call position is closed out in this manner, the investor can decide whether
to make another option transaction to either generate income from and/or protect his shares,
to hold the stock unprotected with options, or to sell the shares.
As expiration day for the call option nears, the investor considers three
scenarios and then accordingly makes a decision. The written call contract will either be
in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money,
he can choose to be assigned an exercise notice on the written contract and sell an equivalent
number of shares at the call's strike price. Alternatively, the investor can choose to close
out the written call with a closing purchase transaction, canceling his obligation to sell stock at
the call's strike price, and retain ownership of the underlying shares. Before taking this action,
the investor should weigh any realized profit or loss from the written call's purchase against
any unrealized profit or loss from holding shares of the underlying stock. If the investor feels
the written call will expire out-of-the-money, no action is necessary. He can let the call option expire
with no value and retain the entire premium received from its initial sale. If the written
call expires exactly at-the-money, the investor should realize that assignment of an exercise
notice on such a contract is possible, but should not be assumed. Consult with your brokerage
firm or a financial advisor on the advisability of what action to take in this case.
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