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Options: Covered Calls

What are they - How do they work

Page Summary:
A covered call in the options market is a common strategy. It is used primarily by long term investors to increase the overall yield on a stock portfolio. Learn more on this page.
Retail clients are starting to see the benefits of covered call writing which is where a call option is sold against a stock already owned.

The reason is simple, it can either enhance the gains on a stock portfolio or somewhat reduce overall losses if the market (or stock) moves lower.

However volatility plays a massive role when looking at whether a covered call strategy makes sense or not. Put simply, if volatility is low then option prices will be low and selling calls against stock is probably an inadvisable trade.

One final point, covered calls are often referred to as 'buy-writes' because the stock is bought and the option is written, written being another way of saying selling short.
A Covered Call example
  • Buy 1000 shares of ABC Industries at £2.15
  • Sell 1 Jul £2.40 call and receive £0.15 per share (or £150)

The trader buys the stock and then sells a call short which pays a credit. The buyer of the call then has the right to buy the stock at £2.40 should it rise above that price at any time before the July expiry.

But for the covered call trader the actual level of where he stops making money on his stock position is not £2.40, it's actually £2.55 because of the £0.15 credit received for selling the option.

Let's look at some potential scenarios that may happen.

ABC Industries trading at £3.00 on expiry
  • Initial cost of 1000 shares bought at £2.15 = £2,150
  • Shares sold (called off us) at £2.40, value = £2,400
  • Option premium received, £0.15 x 1000 = £150
  • Total profit on deal = £250 (shares) + £150 options = £400
  • % gain on capital over 6 months = 18.6%

Yes, in the above example money has been 'left' on the table with the stock now priced at £3.00, but an 18.6% return on capital in less than 6 months is certainly worth noting.

The whole idea about covered call writing is to 'sell' the right of unlimited profits for the 'safety' of lesser but more guaranteed profits.

Alongside this, covered call writing actually reduces risk should the underlying share move lower. This is because the option premium is received.

ABC Industries trading at £2.15 on expiry

  • Make/lose nothing on the initial purchase of shares (1,000 x £2.15)
  • The Jul £2.40 call option expires worthless
  • Keep the option premium received of £150 (1000 x £0.15)
  • Profit on trade (stock & options) = £150 or 6.97%

Can you see why covered call writing is sometimes referred to as 'Income Enhancement'.

By selling the call option against our stock we have made a profit of £150. If we had just held the stock without selling the option our profit/loss would have been £0.

ABC Industries trading at £2.00 on expiry

  • Loss on the shares is £0.15 per share or £150
  • The Jul £2.40 call will expire worthless giving us a profit of £150
  • Profit on trade = £0

Contrast this with if the shares had been bought without selling the option? No £150 credit received and therefore a loss would have been generated of £150 or -7% on capital invested.

ABC Industries trading at £1.75 on expiry

  • Loss on the shares is £0.40 per share or £400
  • The Jul £2.40 call expires worthless, a profit of £150
  • Total loss on trade = -£400 + £150 = -£250 or -11.6%

As an option was sold against the shares the overall loss was reduced from £400 to £250 (37.5%)

Which Options strikes and months should be sold

Strikes

Out of the money calls. If you buy a stock at £5.00 then you should be looking to sell something like the £5.50 or £6.00 calls.

Remember you initially bought the stock because you expected it to rise, therefore you actually want the price to move as close as possible if not slightly higher than the call option strike price by the expiry date.

If you think about it the perfect result for a covered call trade would be for the stock to gently rise and settle at the exact strike price on expiry. That would mean maximum profit on the shares without them being called away, plus of course the option would expire worthless.

Months

You want to be looking at options that have a lot of time value, the more time value the higher the option price.

As a rule of thumb try not to sell options that have less that 2 months to run (unless volatility is very high). Most people who use this strategy look to sell options between 3 and 9 months ahead. So if the month is currently January they'll be looking at the June - September options.

The problem with Covered Calls

It is important not to think in terms of the short call as 'downside protection' because you'll only ever receive a fixed amount of cash. Plus, have you ever heard of an insurance policy that pays you money?

An extreme example -

Say you bought 1,000 shares at £2.00 and sold a call which paid a credit of £0.20. What would your P&L look like if the company went bust?

  • Loss on the shares = £2,000
  • Profit on the options as they expired worthless = £200
  • Total loss on the trade = £1,800

If you hadn't sold the call option and the company again went bust the total loss would have been £2,000. So yes, your total loss will have been reduced by £200 but that's not so much of a consolation.

The point I'm trying to make is that when the markets slump sharply covered calls will only slightly lesson your overall losses assuming the stocks in your portfolio fall significantly in value.

The twist in Covered Calls - It's the same as shorting Puts
The main problem with understanding options is that there's so much misinformation around. This mainly comes from people who understand the basics of options, but no more. It's easy for them to therefore miss many of the subtle points in options trading.

One of the most common points made about options is the incredible risks associated with selling Puts short. By doing this your potential losses could be colossal. For example, sell a load of puts short the day before a stockmarket crash and it's likely you'll be bankrupt within 24 hours.

But the people who warn against the high risks of selling puts short will often remark that covered call type strategies are low risk and are 100% suitable for retail clients.

However, a covered call strategy shares exactly the same risk profile as a short put. Let's look at option payoff diagrams for proof of this. See FAQ on how option payoff diagrams work.

Covered Call payoff diagram

Options - Covered Call

  • Think hard about this - you own the shares and sell a call option against them
  • Your profits are therefore capped in that it's impossible to make any more money if the share price moves above the strike price of the option shorted + the option premium received
  • This is why the fixed expiry line is horizontal (to the right of 'A')
  • Your losses are also fixed because the share price cannot fall below zero
Short Put payoff diagram

Options - Naked Put

  • The option payoff diagram is exactly the same for a short Put versus a covered call strategy
  • Your total profit cannot be more than the premium received for selling the put option short
  • Your total losses are capped because the shares cannot fall below zero
Option payoff diagrams never lie and therefore it is pure nonsense for anyone to suggest that a covered call strategy is low risk while a short put is very high risk. They are exactly the same and traders new to options must bear this in mind.
Leverage has to be considered

However, there is a major distinction to the two strategies and it's got everything to do with leverage, or lack of it.

When a trader enters into a covered call strategy he'll have to pay the full cost of the shares, in effect he's covered all his losses with money upfront. If for example the company were to go broke all the invested cash would be lost but his broker won't be chasing him to pay a debt.

But short options are margined products.

So the trader who sells short a Put might only have to put up a small initial deposit of say £500 - £1,000. But if the share were to suddenly lose 50% of their value overnight the options would explode in value and the trader would have to fund these losses, perhaps to the tune of £5,000 and perhaps a lot more.

So yes, if you use margin to trade short Puts then losses can get out of control extremely quickly and to such an extent that an account can lose all of it's money in a day. It has happened many times in the past. A famous example of this was during the stockmarket crash of 1987.

Apparently, a farmer had been introduced to options and had made a fortune during the first 9-10 months of the year by selling puts short. Basically every put expired worthless and he kept all of the premiums.

But then the crash hit the stockmarket and stocks fell around 20% in one day. Because the farmer was trading on margin all his previous profits were wiped out and by the end of the day, as all put prices exploded, he was bankrupt.

Selling puts therefore is NOT risky if you use NO margin. It's no different from a covered call strategy. But selling puts when using margin can be extremely risky and is not something that people new to options should consider.

Shorting puts is another way to buy stock

Many traders who want to own a share will look to short puts when overall option volatility is high and this trade is related to covered calls.

For example, say you already own some ABC Industries and like the long term prospects of the company. Perhaps you see something that the general market hasn't considered when looking a few years into the future.

Assume your average buy price was £5.00 but then the stockmarket gets hit and the shares slump to £3.00. Not the best of situations but you're not that much concerned. In fact, you might welcome the move as it offers you the chance to buy more shares at significantly cheaper prices.

There are two main strategies to use -
  1. Buy more shares at £3.00, or
  2. Sell short some puts using NO margin
Point 1 is self explanatory. But if you sell puts short how might this trade pan out? Remember, if you short a Put option that gives the buyer of the option the right to sell stock to you at a set price on or before a set date.
  • Assume you shorted 1 of the June £2.50 puts (had 6 weeks till expiry) and received a credit of £0.50 (per 1,000 shares)
  • The buyer of the option now has the right to sell you 1,000 shares at £2.50 but of course he would only do so if the price moved below that level

However, by selling the £2.50 put option short at £0.50 you wouldn't lose on the trade unless the stock fell below £2.00.

Is there any chance of a catastrophic risk and losing all your money? No, because you haven't used any margin. If the shares fell to £1.90 you would still come out ok.

Remember you've already received a £0.50 credit and so even if you had to buy the shares at £2.50 the loss would only be £0.10 or £100. If the share was trading therefore at anything above £2.00 then a profit will have been made.

The profits on short Puts are fixed

The risk if anything on selling a Put short, assuming you want to buy more shares, is that the profit is fixed. When shorting any option you cannot make more than the original premium received.

But if you had bought further shares at £3.00 then profits would be theoretically open-ended as the price could rally to £5, £6, or maybe even £20.

So how would I handle the situation?

I'm a big believer in mixing things up. So I would have probably sold 1 put option short for every 1,000 shares I bought. By doing this I'm receiving some expensive option premium (remember volatility is high) whilst adding to my overall share position.

LearnMoney comment:
A covered call strategy, like most option strategies is relatively simple to understand but of course there are plenty of nuances and subtle points to consider.

The strategy is best suited to long term investors who are willing to forgo unlimited upside potential for a price - the option premium received. The trade should also only be considered for shares you're mildly bullish towards. If you're super bullish don't sell calls as you'll be limiting your upside potential.

Covered calls also work best when option volatility is medium to high. This is because option prices will be expensive and common sense suggests that there's more money to be made by selling something expensive rather than cheap. Remember option volatility at some stage in the future will always revert to its mean.

Finally, if you want to get good with Covered calls and options in general, don't forget to use option pricing and strategy software for your analysis. This cannot be done on paper as options are priced foremost by mathematical models. The software I use is called Hoadley options and it's an Excel add-on.

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