Covered Call

DESCRIPTION: Generally considered an “income” strategy, where one buys as asset and then sells stock against if to collect an option premium. If the call option sold is out-of-the-money, the strategy has return potential comprised of both income and capital gains.

MOTIVATION: The investor who employs a buy-write strategy seeks to increase their income and return profit without increasing the risk of owning stock outright. Selling a call provides limited protection from a drop in the price of the underlying security. The investor gives up high potential returns from a jump in the price of the underlying security. The investor must be willing to give up their stock should this occur.

Action Quantity Expiration Strike Type Net
Sell 1 90 Days $25.00 Call -$1.74
Buy 100 Stock $25.00

OUTLOOK: The investor who sells covered calls is looking for stable or slowly rising asset price over the time to expiration of the call option. This strategy will underperform a holding stock outright in a rising market and only provides limited protection in a bearish scenario.

PROFIT/LOSS: Maximum (Strike – Asset Price, 0) + Premium Received + Dividends
The amount one earns at expiration is equal to the strike price of the call option sold less the asset price or zero, plus the initial premium collected, to sell the call. The Investors is also entitled to the dividends paid by the company if any.

MAXIMUM GAIN: (Strike – Asset Price) + Premium Paid + Dividends
Just like with a stock, there is no upside limit to the gains one can make by owning a call option.

MAXIMUM LOSS: Asset Price – Premium Received
The maximum one can lose is the value of the stock purchased less the premium collected on the call option sold. This would occur if the value of the stock goes to zero, which could happen in a bankruptcy scenario.

BREAKEVEN: Asset Purchase Price – Premium Paid
The investors will breakeven if the asset price fall by an amount equal to the premium collected when selling the call option at expiration.

VOLATILITY: An increase in implied volatility would have a small negative impact the profitability of a covered call position. This impact is relevant if the investor wanted to buy the call back sometime before option expired. An increase in realized volatility increases the probability that the stock will be called away or fall substantially in price.

TIME DECAY: Time decay has a positive impact of the performance of a buy-write strategy. In fact, time decay is the reason why people sell calls against their stock. They sell an option with the hope that it will expire worthless so they can do it again and again.

ASSIGNMENT RISK: None. If the stock is called away, the investor simply delivers the stock they hold against the call option and receives cash.

EXPIRATION RISK: Not very much. The seller of the call will either continue to own their stock or get cash equal to the stock price at expiration. If the stock is called away, they can repurchase it the following day and sell another call if they choose. If the still own the stock, they can sell another option the following day and continue with their income strategy.

STRATEGY PAIR: The profit/loss payoff profile for a cover-call strategy is the same as that for the cash covered put option strategy. Put-call parity suggests that stock plus a put is equal to cash plus a call. So stock less a call is equal to cash less a put.