Covered Calls

The covered call is a strategy in options trading whereby call options are written against a holding of the underlying security.

Covered Call (OTM) Construction

Long 100 Shares Sell 1 Call

Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.

However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset.

Out-of-the-money Covered Call

This is a covered call strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains (albeit limited) if the underlying stock rallies.

Limited Profit Potential

In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold.

The formula for calculating maximum profit is given below:

• Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid
• Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Unlimited Loss Potential

Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. However, this risk is no different from that which the typical stockowner is exposed to. In fact, the covered call writer's loss is cushioned slightly by the premiums received for writing the calls.

The formula for calculating loss is given below:

• Maximum Loss = Unlimited
• Loss Occurs When Price of Underlying < Purchase Price of Underlying - Premium Received
• Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the covered call (otm) position can be calculated using the following formula.

• Breakeven Point = Purchase Price of Underlying - Premium Received

Example

An options trader purchases 100 shares of XYZ stock trading at $50 in June and writes a JUL 55 out-of-the-money call for $2. So he pays $5000 for the 100 shares of XYZ and receives $200 for writing the call option giving a total investment of $4800.

On expiration date, the stock had rallied to $57. Since the striking price of $55 for the call option is lower than the current trading price, the call is assigned and the writer sells the shares for a $500 profit. This brings his total profit to $700 after factoring in the $200 in premiums received for writing the call.

It is interesting to note that the buyer of the call option in this case has a net profit of zero even though the stock had gone up by 7 points.

However, what happens should the stock price had gone down 7 points to $43 instead? Let's take a look.

At $43, the call writer will incur a paper loss of $700 for holding the 100 shares of XYZ. However, his loss is offset by the $200 in premiums received so his total loss is $500. In comparison, the call buyer's loss is limited to the premiums paid which is $200.

Note: While we have covered the use of this strategy with reference to stock options, the covered call (otm) is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Summary

Overall, writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call.

Similar Strategies

The following strategies are similar to the covered call (otm) in that they are also bullish strategies that have limited profit potential and unlimited risk.

Collars

As the covered call writer is exposed to substantial downside risk should the stock price of the underlying plunges, collars can be created to reduce this risk thru the use of put options.

In-the-money Covered Call Strategy

In-the-money covered call options are sold when the investor has a neutral to slightly bearish outlook towards the underlying security as their higher premiums provide greater downside protection.

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