Understanding
Stock Options Trading
and Technical Analysis Basics

Covered Calls -
a Synthetic Short Put Strategy

Writing or selling Covered Calls are a "moderate" investor's favorite strategy. It's so conservative that some retirement funds allow this strategy in their portfolio. It works particularly well when the stock in question doesn't move dramatically up or down, but rather just trends sideways. Basically, it works for stocks that are deemed too "boring" for option plays.

The Covered Call is a type of Synthetic Short Put strategy. These are "synthetic" strategies that have the same potential as other trading strategies. In this instance, a covered call is a Synthetic Short Put because it has the same earning potential as a Short Put option.

There are two main reasons for writing covered calls. The first is to provide monthly income on stocks that you already own but are not moving much. The act of writing the call will generate income from earning the option premium, and this can be repeated every month if the underlying stock price does not move. The second reason is to increase the loss tolerance of the underlying stock. Since you earn the option premium when writing the call, the stock price will not need to go as high in order for your investment to break even or reach a target profit.

Covered Call - Buy Underlying Stock, Sell 1 ATM Call

The term "writing" refers to the act of selling stock options. So when we write covered calls, we are actually selling a call option. Buying a call option gives you the right, but not the obligation, to buy a stock at a specified price at a specified date. Conversely, if you sell a call option, you now have the obligation to sell the stock to the option buyer at the agreed upon price at the specified date. So a Call Writer is agreeing to the obligation to sell stock, while a Put Writer is agreeing to the obligation to buy stock.

Summary:

When you are Writing or Selling stock options, you are agreeing to the obligation to fulfill the option contract, which is to sell stock in the case of a Call, or to buy stock in the case of a Put.

When you buy an option, you buy the option to Open a Position, and sell it later on to Close the Position. Similarly, when you Write options, you write the option to Open the Position, and you must Close the Position somehow, whether it's by letting the option expire worthless, or by buying the option back.

In the case of selling Call options, remember that Call options are more In-The-Money the higher the stock price goes. So if you sell a Call option and the underlying stock price goes down below the option's strike price (meaning the option becomes Out-Of-The-Money), the option will expire worthless. You therefore don't need to do a thing, and can pocket the profit you earned by selling the option.

However, the danger happens when the stock price keeps climbing. If it keeps going up, it will never become worthless, and come expiration day, someone is going to exercise the option and buy the stock from you. You will therefore be Called Out. The problem is you don't own the stock. You would need to buy the stock at the current market price (which has gone up), and sell the stock to the option buyer at the previously agreed strike price, which would have been lower. This would cost you a lot!

Let's take a look at a numerical example:

Say the price of stock ABC is now sitting at $18. You sell a Call option for a strike price of $20, expecting the stock to hover around the $18 level. Let's say you earned $1.00 on the option premium (which is $2 Out-Of-The-Money).

Scenario 1: If by expiration day the stock price ends up at $19, which is below the strike price of $20, you're fine, since the option is Out-Of-The-Money and will expire worthless.

Scenario 2: What if by expiration day the stock price jumps to $26? The option is now In-The-Money by $6, and you have been Called Out. So you will need to buy the stock at the current market value of $26, then sell it to the option buyer at $20. That's a loss of $6 for you, and if you include the $1.00 you made earlier, still results in a nett loss of $5.00.

Let's look at this in tabular format:

Scenario 1 Scenario 2
Premium earned $1.00 $1.00
Strike price $20 $20
Final stock price $19 $26
In-the-money? Out $1 In $6
Cost of stock purchase --- $26
Earnings from stock sale --- $20
Total profit $1.00 - $5.00

And that's just if the stock price goes up to $26. What if it had gone higher, to say $36? Your losses would increase by another $10. Considering that one contract covers 100 underlying shares, that's a lot of money. Therefore, selling stock options on their own, also known as selling Naked or Uncovered options, is extremely risky.

Summary:

Selling stock options on their own is known as selling Naked or Uncovered options. They are extremely risky, and can result in unlimited losses.

In order to lessen that risk, what we can do is to actually buy the underlying stock the same time we sell the option. For example, if you want to sell 1 contract of ABC options, you would buy 100 shares of the ABC stock at the same time (remember that 1 option contract is equivalent to 100 underlying shares). By buying the shares, we eliminate the risk of having to buy the shares later at a higher price in case we get called out. This is called covering your call writing, ie. we just wrote a Covered Call.

Let's return to our numerical example, but this time we write covered calls on it. Previously, we sold a $20 Call option for a premium of $1.00 when the stock was currently at $18. This time, we also bought 100 shares of the stock at $18. Let's look at 2 scenarios, one where the stock went down in price, and another where the stock climbs above the option strike price.

Scenario 1: If the stock price falls to $17 by expiration day, the option expires worthless and we are not called out. We lost $1.00 because we bought the stock at $18 and it's now at $17. However, since we previously sold the option for $1, we actually broke even. And we still own the stock.

Compare this with just a simple purchase of the stock. When we write covered calls, ie. selling an option together with buying the stock, we actually increase our loss tolerance by the option's premium amount. In this example, we increased out loss tolerance by the option premium of $1, meaning we could afford to have the stock drop $1 without actually losing anything.

That is our break even level. As long as the stock price stays above that level, we profit. Anything less and we lose. That's why we need to look at stable or moderately bullish stocks to consider for our covered call trades. This is important in the stock market, where stocks we buy usually don't go up the way we expect them to...

Scenario 2: If by expiration day, the stock goes up to say $26, we would be called out. However, there is no risk, because we already own the stock, and can just sell it immediately. However, since we already agreed to sell the stock at $20, that is the price we have to honor. So we sold the stock at $20. In total, we earned $2 from selling the stock ($20 minus the $18 we spent earlier), and earned another $1 from selling stock options earlier on. That's a total $3 profit.

Let's look at this in tabular format:

Scenario 1 Scenario 2
Cost of stock $18.00 $18.00
Premium earned $1.00 $1.00
Strike price $20 $20
Final stock price $17 $26
In-the-money? Out $3 In $6
Earnings from stock sale --- $20
Change in value of held stock - $1.00 ---
Still keep the stock? Yes No
Total profit $0.00 $3.00

Now let's take a look again at Scenario 1. The Call option has expired worthless, and we keep the stock. This means that month after month we can keep selling stock options on those 100 shares we own, and as long as we don't get called out, we can make constant monthly income. And what if we get called out? As Scenario 2 shows, getting called out still earns us a profit.

This is how investors write covered calls to generate a monthly income. This strategy usually earns about 3% to 15% a month. Not bad for a strategy that's almost risk-free! However, do note that if you are unlucky enough to choose a stock that keeps falling lower and lower, no strategy is going to help you! (Unless you buy a Put option on that stock to reduce your losses).

Summary:

We write covered calls by buying stocks to cover an option sale. This is a conservative strategy that can be used to create monthly income, by selling call options month after month.

On a side note, some investors who have held particular stocks that haven't moved for a long time can also decide to write Covered Calls. They can sell call options on their stock, and either earn monthly income on the stocks, or (sometimes hopefully!) get called out and sell their stocks, getting back their capital to invest elsewhere.