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Writing Covered Calls |
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From looking at Straddles, which thrive on
volatility, we now take a look at a strategy
that's much more conservative. It's so conservative
that some retirement funds allow this strategy
in their portfolio. Writing Covered Calls are a "moderate" investor's favourite strategy. 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. |
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Writing
Covered Calls is an extremely conservative
strategy that works best on stocks that don't
move much in price. |
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| So far,
we've only considered buying options. For writing
Covered Calls, we need to take a look at the opposite
side of that transaction, which is selling stock
options . The term "writing" refers
to the act of selling stock options. So when we
write covered calls, we are actually selling a call
option. To recap, 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. Taking a look at our housing example earlier on, the owner of the house basically wrote / sold an option to us by promising to sell us the house at the agreed price. We could decide whether we wanted to buy the house, but if we did want to buy it, the house owner is required to sell it. He does not have the luxury of saying no. So a Call Writer is agreeing to the obligation to sell stock, while a Put Writer is agreeing to the obligation to buy stock. |
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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. |
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Scary isn't it? Who would want to enter a
contract with such obligations? The good part is, when you sell an option, you receive the Premium of the option. Which means you instantly make money from a transaction. In that case, why doesn't everyone start selling options? Let's take a closer look at selling Call options. To recap: 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 have been 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: |
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| 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. |
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Selling stock
options on their own is known as selling
Naked or Uncovered options.
They are extremely risky, and can
result in unlimited losses.
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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 writing covered calls. 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: |
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| 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 to buy 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). |
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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. |
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| 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. |
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