Writing covered calls is an options strategy that involves selling call options on a stock that you already own. This way, you can generate income from the option premiums and also limit your downside risk if the stock price falls. However, you also give up some of the potential upside profit if the stock price rises above the strike price of the call option.
A call option is a contract that gives the buyer the right, but not the obligation, to buy a stock at a certain price (the strike price) within a certain time period (the expiration date). The seller of the call option receives a fee (the premium) for giving up this right.
When you write a covered call, you own the underlying stock and sell a call option on it. For example, if you own 100 shares of XYZ stock trading at $50, you can write a call option with a strike price of $55 and an expiration date of one month later. You might receive $1 per share as the premium for selling this option.
By writing this covered call, you have three possible outcomes:
- If the stock price stays below $55 until the expiration date, the option will expire worthless and you will keep the premium of $100 ($1 x 100 shares) as your profit. You will also still own the stock, which may have increased in value up to $55.
- If the stock price rises above $55 before the expiration date, the option buyer will exercise the option and buy the stock from you at $55. You will lose the stock, but you will still keep the premium of $100 and also make a capital gain of $500 ($5 x 100 shares) from selling the stock at a higher price than you bought it.
- If the stock price falls below $50 before the expiration date, the option will expire worthless and you will keep the premium of $100 as your profit. However, you will also incur a capital loss from the decline in the stock value. The premium will partially offset this loss, but not completely.
Writing covered calls can be a useful strategy for investors who want to generate income from their stock holdings and are willing to limit their upside potential. However, it also involves giving up some control over the stock and taking on the obligation to sell it if the option is exercised. Therefore, it is important to understand the risks and rewards of this strategy before using it.
Basic Theory:
A covered call involves two key components:
- Long Stock Position: The investor holds a certain amount of a particular stock in their portfolio.
- Short Call Option Position: Simultaneously, the investor writes (sells) call options on the same stock. Each call option represents the right (but not the obligation) for the option holder to buy the underlying stock at a specified price (strike price) before a specified expiration date.
By writing covered calls, the investor receives a premium for selling the call options, providing additional income on top of any dividends received from holding the stock.
Procedures:
- Select a Stock: Choose a stock that you already own or are willing to buy. Consider stocks with stable prices and moderate volatility.
- Choose a Strike Price and Expiration Date: Decide on the strike price at which you’re willing to sell the stock if the option is exercised and choose an expiration date for the options contract.
- Write (Sell) Call Options: For each 100 shares of the stock you own, sell one call option. The premium received from selling the call option is yours to keep, regardless of whether the option is exercised.
- Monitor and Manage: Keep an eye on the stock’s performance and be prepared to buy back the call option or let it expire if the stock’s price approaches or exceeds the strike price.
Comprehensive Explanation with Excel Formulas:
Let’s consider a scenario with the following details:
- Stock: XYZ Corp
- Current Stock Price: $50
- Number of Shares Owned: 200
- Call Option Premium (for one contract): $3
- Strike Price: $55
- Expiration Date: 30 days from today
Scenario Calculation in Excel:
- Initial Investment:
- Stock Value = Current Stock Price * Number of Shares Owned
- Initial Investment = Stock Value
- Premium Received from Call Options:
- Premium Received per Contract = Call Option Premium
- Total Premium Received = Premium Received per Contract * (Number of Shares Owned / 100)
- Total Return:
- Total Return = Initial Investment + Total Premium Received
- Breakeven Price:
- Breakeven Price = Current Stock Price – Total Premium Received per Share
- Profit and Loss at Expiration:
- If Stock Price <= Strike Price: Profit = (Strike Price - Current Stock Price) * Number of Shares Owned + Total Premium Received
- If Stock Price > Strike Price: Profit = Total Premium Received
Excel Table:
| Item | Formula | Value |
|---|---|---|
| Initial Investment | = Current Stock Price * Number of Shares Owned | $10,000 |
| Premium Received | = Call Option Premium * (Number of Shares Owned / 100) | $600 |
| Total Return | = Initial Investment + Total Premium Received | $10,600 |
| Breakeven Price | = Current Stock Price – (Total Premium Received / (Number of Shares Owned / 100)) | $48.00 |
| Profit and Loss at Expiration | = IF(Current Stock Price <= Strike Price, (Strike Price - Current Stock Price) * Number of Shares Owned + Total Premium Received, Total Premium Received) | Varies based on stock price at expiration |
Result of the Scenario:
- Initial Investment: $10,000
- Premium Received: $600
- Total Return: $10,600
- Breakeven Price: $48.00
Other Approaches:
- Adjusting Strike Prices: You can adjust strike prices based on your outlook for the stock. Higher strike prices offer more premium but lower protection.
- Rolling Options: If the stock’s price approaches the strike price, consider rolling the options by buying back the current options and selling new ones with later expiration dates.
- Collar Strategy: Combine covered calls with protective puts to limit potential losses. Buy a put option with a strike price below the stock’s current price to hedge against a significant decline.
