Covered Call Basics

The Covered Call Defined

A covered call is the sale of call options against shares of stock the seller already owns, or bought specifically for that purpose. The writer of call options is legally obligated to deliver the underlying shares if assigned on the calls. When the call writer owns the underlying shares, his obligation to deliver those shares if called out is covered. So a covered call is simplicity itself:

  • Write (sell) call options
  • On shares you bought for that purpose (or already own)

The covered call writer is in essence selling someone else the right to buy the underlying stock for a fixed term and specified price. When the call writer does not own the underlying stock, the calls are said to be naked. Since the stock price could go up significantly, the naked call writer could be badly damaged if forced to go into the market to buy the underlying shares at the higher price in order to deliver them at the calls’ strike price. In 2004, shares of OSIP Pharmaceuticals gapped up overnight from $39.90 into the $90s. Anyone who had written OSIP calls naked at the $40 or $45 strikes would have been pretty much wiped out by having to buy the stock above $90 and deliver it at the strike price!

The following table illustrates how a covered call trade is constructed. Assume it is November, with 30 days left until December expiration; we buy 500 shares of Cisco Systems (CSCO) and sell the CSCO December 20-strike calls (DEC 20C) against those shares:

                 Figure 4.1

Covered Call Trade
Cisco Systems, Inc. (CSCO) Per Share Total
Buy 500 shares of stock – $19.75 – $9,875.00
Sell 5 DEC 20 Calls + $   1.25 + $     625.00
Net Debit (cost basis) – $18.50 -$9,250.00

 

EXPLANATION: We paid $19.75 ($9,875 total) for the shares but received a $1.25 premium per share ($625.00 total) for writing the 20 Calls, thus the stock only cost us $18.50 ($9,250.00 total). Because each call contract covers 100 shares, we must sell 5 of the DEC 20C contracts in order to cover all 500 CSCO shares. The $625 in premium sets up a potential return of 6.75% for a 30-day trade, which is an excellent return; 6.75% for a month works out to an 81% annual return.

Your trading account would be debited for the $9,250 stock cost and the trade commissions, but the account now contains 500 shares of CSCO worth $9,875. The goal is to sell the shares at option expiration for $19.75 or better, which would lock in the $625 call premium as a profit. If the stock is sold for less than $19.75, the return will be smaller than the $625 in premium raked in. But if the stock is called out at the $20 strike price, or sold at any price above $19.75, we will keep all the original $625 in premium and receive an extra profit in addition. The table below illustrates these points:

Figure 4.2

Comparison of Covered Call Results at Expiration

Cost Basis = 18.50 Profit Comment
Sell stock at 19.75 625.00 We get back the same price paid, so the return is the 1.25 in call premium received. Return is 6.75%.
Sell stock at 20.00 750.00 We picked up an extra 0.25 per share, which increased the return from 1.25 to 1.50 per share. Return is 8.1%.
Sell stock at 19.00 250.00 We realized a loss of $0.75 per share on the stock when it was sold after expiration (not called); this decreased the return from 1.25 to 0.50 per share. But the trade still showed a profit, even with the stock’s drop. Return is 2.7%.

These examples do not take trading costs into account, which would be reflected in the final return.

Two Main Types of Covered Calls

  1. Buy-write: this is another name for the covered call trade, since the trader buys the stock and writes the calls against it. The buy-write is considered a primary strategy, because the goal is to produce covered call income; the purpose is not to keep (invest in) the underlying stocks. The buy-write is the foundation of the strategy and most covered call strategies.
  2. Overwrite: means to write calls on portfolio stocks in order to generate a stream of premium income – force them to “pay rent”. The overwrite is considered an ancillary strategy, since writing call options is tangential to the investor’s main purpose of profiting from the stock’s hoped-for price gain.

Requirements for a Valid Covered Call

A valid covered call write requires three things:

  1. The underlying stock and short calls both must be held in the same account.
  2. The shares owned must be the exact stock underlying the calls.
  3. The calls must be fully covered.
    (we must own enough shares to deliver in the event all calls are exercised)

We don’t have to write calls against all underlying shares owned. Many portfolio writers will only write against 50% to 70% of their portfolio stocks. Doing so produces an income but does not expose the entire portfolio to being called out. However, to avoid writing naked calls, we must own at least as many underlying shares as will cover the calls written. If we write 5 contracts of a call option and have only 300 shares of the stock in our account, we would be naked for 2 contracts, since 500 shares would be needed to cover all the calls. We will see later how long calls also can “cover” short calls.

Always make sure that the trade order you enter reflects the trade you intended to run! Should you accidentally write naked, you will be liable for any losses. Your broker’s trade platform probably will not allow you to write naked if unapproved for it; and if you manage to put on a naked write despite lacking the approval, the broker likely will buy the calls to close to protect itself; it’s your risk.

Covered Call Profit and Loss Graph

The profit and loss graph clearly illustrates the virtues and risks of the covered call trade. Using our CSCO covered write above, the graph shows our potential results from buying the stock at $19.75 and writing the 20 Call for a $1.25 premium. How will the position behave?

Figure 4.3

Note first that the position line crosses the zero (breakeven) line precisely at the $18.50 breakeven point (19.75 – 1.25 premium).

The call write has lowered our risk in the stock from the $19.75 purchase price to $18.50.

At any price above $18.50 at expiration, we will not take a loss. Even if the stock is at $19 on expiration, we still are ahead $0.50 before trade costs.

Although we received only $1.25 in total premium, if called out at the $20 strike price we receive an extra profit of $0.25, for a total of $1.50. This $1.50 is our maximum profit in the trade, which is why the position line becomes flat at the $1.50 profit level.

No matter how high the stock rises, then, our maximum profit remains $1.50. One who is extremely bullish on a stock over the short term might not wish to write covered calls on the stock. But this trade-off in certain premium today versus a potential gain tomorrow highlights the entire purpose of covered call writing: to force an income out of stocks; to in effect force stocks to pay us a monthly dividend.

But of course, the covered call trade is not riskless. If the stock is below $18.50 at expiration, we will take a loss, assuming no action is taken to modify the trade. For example, if the stock is at $15 at expiration, the graph shows that we would be in a $3.50 loss position. In this case, we have NOT lost $3.50, though the position obviously is impaired.

For example, even though the stock is down we could continue writing calls to generate income – the reason we bought entered the trade in the first place. Significantly, we had alternatives for managing the trade long before it got to a low point, as we will discuss in detail further on.

Covered Call Breakeven-Profit Graph

Figure 4.4 following illustrates the above covered call profit-loss potential in a slightly different schematic. The $1.50 profit zone (the gray band) lies between the $20 Call strike and the $18.50 breakeven price.

      Figure 4.4

      As Figure 4.4 at left shows, if the stock is $20 or higher at expiration, we realize the position’s maximum profit of $1.50.

Below $18.50, we may face a loss. It is possible to avoid exercise and to take steps to avoid or minimize a loss by managing the position, however.

If no trade modifications are made, this covered call position has a $1.50 zone of profitability. Because the call was ATM when written, there will be no extra profit to us if assignment occurs.

Call Strikes – Protection and Returns

I firmly believe (as I discuss further on) that the stock will tell you how to write it. A review of the stock’s fundamentals, of the technical performance of the stock and its industry, and the state of the market itself will suggest which call strike to write. This table illustrates the basic strike dynamics:

Figure 4.5

Call Strike Characteristics

Strike Downside Protection Level of Return (Time Value)
OTM Smallest downside protection; all time value Highest return if assigned. Returns can be poor in flat and declining markets.
ATM Medium level of protection; all time value Consistently (but not invariably) the fattest return in all markets.
ITM Greatest downside protection Generally the smallest return, but the return can be surprisingly high in a declining market or if implied volatility is high.

 

The hierarchy of returns from highest to lowest generally will be: ATM, then OTM, then and ITM. The stock often is not conveniently at an ATM strike, so many times the “ATM” option actually will be near the money. An OTM call will never offer a higher uncalled return than an ATM call. When the stock price is between strikes, the OTM often will present a higher return than the lower strike call that is a bit ITM, though it will provide less downside protection

The table below illustrates the relationship of call strikes to a stock price of $20.17. Despite the fact that the 20 Call is a few cents in the money and thus is near the money (NTM), it essentially is considered, and almost always will behave as, an at-the-money (ATM) strike.

Figure 4.6

Call Strike Analysis

Strikes Status Premium Intrinsic Value Time Value

Cost Basis

17.50 ITM 3.25 2.67 0.58 16.92
20.00 ATM (NTM) 1.10 0.17 0.93 19.07
20.17 Stock Price        
22.50 OTM 0.70 0.00 0.70 19.47
25.00 OTM 0.40 0.00 0.40 19.77

As expected, the fattest time value is in the ATM $20 call strike, which really is slightly ITM. However, the OTM 22.5C offers nearly as much time value ($.70 vs. $.93). And if the stock is higher than $20.17 at expiration but $22.50 or less, additional profit will be realized from the sale of the stock at a price above $20.17. If bullish in the short term, the OTM call is the better bet; if not, the ATM provides a larger return uncalled. The OTM 25C is extremely bullish; if this bullish, why write the call immediately for only $0.40 in premium, which will hardly lower the cost basis? It might make more sense to buy the stock and wait to write the 25C as the stock actually advances, a far more bullish (and speculative) approach.

One who is concerned about a short-term pullback in the stock, or just very conservative, might prefer writing the ITM 17.5C, which would lower the cost basis to $16.92, even though it is a weaker return – but still is 3.4% if assigned (0.58 ÷ 16.92).

Covered call writing requires making precisely these kinds of discernments: which stock, which call strike, which expiration month?

Writing further out in time – a further expiration month – brings in more premium, but as explained earlier, premium compression will work to pick your pocket, lowering the return per month. As we have also seen, time decay is the call writer’s friend, and the further out in time we write, the less aggressively time decay works in our favor. And as we will see, delta can also pick your pocket in calls further out. For these reasons, I rarely write even the next month out unless there is not much left of the current expiration month.

One of the most vexing issues in covered writing is which strike to write. Go for the fattest premium today (ATM), go for less return but more downside protection (ITM) or go for the gold, if bullish (OTM)? The article on trade planning will shed considerable light on this determination.

And of course, selecting stocks to write for covered calls requires some care. If is not difficult, as we will see, but requires patience and discipline, as does all consistently successful investing.