Covered option
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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.
Examples
An investor has 500 shares of XYZ stock, valued at $10,000. He sells 5 call contracts for $1500, thus covering a certain amount of decrease in the XYZ stock (i.e. only after the stock value has declined by more than $1500 would the investor lose money overall). Losses can not be prevented, but merely reduced in a covered call position. If the stock price drops, the buyer of the call can not exercise the option because contractually the stock price must be above the strike price, and the seller (writer) keeps the money paid on the premium of the option, thus reducing his loss from a maximum $10000 to $10000-(premium).
This "protection" has its own disadvantage in which the investor is forced to sell his stock if the option is "called out" in which the writer is forced to sell his stock below market price or he must buy the calls back at a higher price than he sold them for.
The investor might repeat the same process again next month if he/she believes that stock will either fall or be neutral, if before expiration stock price does not reach strike price.
A 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.
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 |
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.
