Wednesday, February 10, 2016

Covered Call Writing, Examples and Call Option Strategy

Writing covered calls is the process of shorting a call option - usually to generate income, while owning the stock that is the same as the stock on the call option. The term "covered" means that if the Option is exercised, the investor engaged in this strategy has the stock to meet the obligation - which is the delivery of shares of stock that the short call requires.

That is a mouthful!  It is best - and easier to understand covered call strategies by using examples.

If we set up a position, we can examine the thought process behind it and thus be able to understand and figure the gain. loss and break-even figures.

First, there are terms that mean the same thing.  This will make it easier when you are reading or listening to covered call strategies or any option strategy.

LONG  =   BUY = HOLDER/BUYER
SHORT = SELL = SHORTER/SELLER

COVERED CALL OPTION STRATEGY EXAMPLE 1

An Investor (trader) has set up the following position. *These positions do not have to be set up simultaneously. The stock position can be established before or after the option contract.

LONG 100 Shares DFG @ 68
SHORT 1 DFG APR 75 Call @ 3.50

This is a covered call strategy. The investor bought 100 shares of the stock at $68. The purpose of the call option contract is to support the stock. The option is not the main focus or investment liability. "APR" means April and is the expiration month. This contract will expire worthless if it is not bought back or exercised before April.

Selling or shorting calls with stock is mainly done to generate income. The $350 received by the trader is immediate income. It also lowers total cost on this combined position. Before an option was established, the stock's cost and break-even (disregarding unknown commissions and ticket charges etc) was 68. However, the option lowers that cost and break-even to 64.50. This investor has a net outlay of $6,450 or a break-even of 64 1/2. 

The call allows for the stock to drop 3 1/2 points and the investor is still OK. Any drop below that and the position is losing money. Writing calls is not a strategy for protecting the stock. You cannot protect a stock by shorting options. That is not the purpose here. If the person bought a PUT - then it is protected, but it would not produce income. Only "selling" gives income and only "buying" protects. Never both.

Important to remember: If a call is exercised before the expiration it means the shorter must sell or deliver 100 shares of the stock (per contract) at the strike price to satisfy the obligation. In this case, the price that must be met is 75.

Since the stock can theoretically drop to 0, the entire value of the net position is at risk. So the maximum loss here is the full value of $6450. 

The maximum gain is "limited" while the option is hanging out there. An option can be exercised at any point, but it is most likely going to happen in a rising market. The Call holder is the boss and decision maker. Owning a call gives that person the right to own the stock at the strike price of 75. Obviously if the price falls to 65, 60 or any price that is well below the market vs. the strike price, the trader owning the option will not be interested in buying the stock at 75 as it says on the contract. Buy Low, Sell High always applies. Thus, ALL CALL OPTIONS are most likely to get exercised when the market rises. 

Given that fact, the maximum gain in the example above is "capped". Normally a person owning shares would have an unlimited gain potential, but since this option carries an obligation to sell it at 75, the gain starts with the difference between stock cost (68) and strike price (75), which is $700 PLUS the $350 premium received. The Maximum gain is $1050.

If the option expires, and the stock then rises substantially, the trader wins all around. He keeps the premium and the stock now has an unimpeded rise potential indefinitely for as long as he holds the stock.

Covered call writing is usually initiated when an investor feels the stock will hover within a trading range, or even drop some and writing a call gives him income during that period.

I hope that helps your understanding of Covered Calls.

Feel free to post questions, and visit American Investment Training for more resources including Broker Exam Training Courses

American Investment Training (AIT)

Pearson Education (myPEARSONstore)

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