Investment Strategies

Covered Call Strategy

A covered call option is a contract sold or “written” on a long underlying asset owned by the call option writer, for a premium.  Thus, the call option is “covered” by the underlying asset.  A call option gives the buyer the right, but not the obligation, to buy a predefined asset at a predefined price over a predefined period of time. 

While there is potential for investment loss with some option strategies, this is not always the case. For instance, selling covered call options is one popular strategy that can produce a regular flow of income and still provide the opportunity for capital appreciation. This strategy can also help reduce the risks associated with owning stocks, as well as helping to lower the overall volatility of an investment portfolio.

There are many ways to execute on a covered call option strategy – ranging from simple to complex. In this article we will stick to some of the basics to help you better understand how covered call options work.

Definitions

Exercise: When the option buyer chooses to execute on the right to purchase the underlying stock according to the terms of the contract, he or she is said to be “exercising” the option.

Premium: The amount that the option buyer pays the option seller in order to enter into the contract.

Strike price: This is the price at which the buyer of the option can purchase the underlying stock any time up to the option’s expiry date.

Write: When an investor owns a stock and chooses to sell call options on that stock, he or she is “writing” the contract for this option.

Call Options

A call option is a contract which allows the purchaser to benefit from a rise in the stock price over a limited time period. Each contract has a stated exercise, or “strike”, price which is the price at which the purchaser has the option to buy the underlying stock. If the stock price rises above the exercise price, the purchaser will exercise their option. If the stock price falls below the exercise price, the purchaser will let the worthless option expire. The price of the option will be determined based on the difference between the stock price and the exercise price, the volatility of the underlying stock (where greater volatility leads to a higher price) and the time to expiration of the option contract (where a longer time period leads to a higher price).

A covered call option strategy is implemented by selling a call option contract while owning an equivalent number of shares of the underlying stock. This is generally considered to be a conservative strategy because it decreases the risk of stock ownership while providing additional income; however, it caps upside potential on price increases above the strike price at which the call option is sold. For example, if you own ABC Co. which is trading at $10 and sell a call option with a strike price of $10.50, you do not get any capital appreciation above $10.50 if the stock price of ABC Co. rises through the $10.50 strike price prior to the expiry of the option.

The covered call option strategy allows the portfolio to generate additional income from the call option premiums in addition to the dividend income from the underlying stocks.

First Asset’s 25% Covered Call Strategy

An option “contract” consists of 100 shares of the issuer in question, so in order to write on 25% of the shares of a specific company a portfolio must own at least 400 shares. As an example, consider a portfolio that holds 400 shares of ABC Co. (ABC) at a current price of $50, for a total value of $20,000. At-the-money (ATM) call options (exercise at $50) that expire in 30 days are valued at a premium of $2.00 per contract. To implement a 25% covered call strategy, the portfolio writes call options on 100 ABC shares (one contract) and receives $200 in premium. The balance of the portfolio (75%) is considered uncovered and thereby entitled to all of the potential capital appreciation.

If the stock price remains at $50, the call option contract is not exercised, and the portfolio benefits from the premium received. The new portfolio value is $20,200.

Payoff without exercise: Premium received adjusted for any difference in stock price.

If the stock price drops to $49.50, the calls are not exercised, but the portfolio value drops. The new portfolio value is $20,000 ($19,800 + $200) which is the break-even point. The portfolio will devalue at any price below $49.5.

Break-even point: Stock purchase price less premium received.

If the stock price rises to $51, the calls are exercised at $50 eliminating the benefit of the rising stock price on 25% of the portfolio (ie: you forgo $100 in capital appreciation), except for the premium received. The new portfolio value is $20,500 ((300*$51) + (100*$50) + (100*$2)).

Payoff with exercise and capital appreciation: Premium received adjusted for any difference between stock price and exercise price.

Impact of Market Conditions on a 25% Covered Call strategy

The covered call option strategy is most effective in sideways to slightly rising markets. First Asset’s strategy will capture at least 75% of the upside in a sharply rising market, and provide some downside protection in declining markets.

When the stock price rises significantly and exceeds the exercise price, the call option will move “into-the-money”. This caps the gain for the call option seller based on the premium received which is equal to 25% of the portfolio in this strategy.

The strategy only provides limited protection when the stock price declines significantly, as the decline of the underlying stock portfolio is partially offset by the call premium received.

Participate in covered calls using ETFs

A covered call option strategy tends to be suitable for conservative investors who want to generate income and partly protect against a decline in share price. In addition to applying this strategy to individual stocks, you can invest in ETFs dedicated to covered call option strategies. For instance, an ETF could be a portfolio of all the securities held in a particular index, with covered call options written for some or all of those securities. Thus you would have exposure to a covered call strategy without having to write the call options yourself.

Covered call ETFs are a convenient way to participate in most of the capital appreciation potential of a basket of securities that mirrors a given index, while receiving a regular income stream that offers a degree of downside protection for the portfolio.


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