A Covered Call, also known as a Buy-Write, is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income.
For example, let’s say you own 100 shares of fictional stock XYZ, which is currently trading at 25. You then sell one XYZ August 26 Call (expiring 8/16/2014) for $1 for each of your 100 shares. Because you don’t have a position in the call until you execute this trade, this would be an order to “Sell to Open.”
Let’s take a look at a few scenarios for this trade:
In scenario 1, XYZ shares trade flat for the next month and the stock stays below the 26-strike price. The options you sold will expire worthless and you will have collected your full premium of $1 per share ($100). Thus you will have created a yield of 4% in one month’s time. I also refer to this in my daily emails as “Static Return.”
In scenario 2, XYZ shares fall to 24. The options you sold will expire worthless and you will have collected your full premium of $1 per share ($100). However, your 100 shares of XYZ will have lost $100 of value. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls against your stock position.
In scenario 3, XYZ shares fall to 23. The options you sold will expire worthless and you will have collected your full premium of $1 (or $100). However, your shares of XYZ will have lost $200 of value, so you would be down $100 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
In scenario 4, XYZ shares rise above 26. The owner of the 26 calls will exercise his right to buy the stock from you, leaving you with no position. However, you have collected your $1 (or $100) from your call and your stock position has appreciated another $100. You are up $200 on the trade and have created a yield of 8% in one month’s time. At this time, you can move on to another trade or buy the stock again and sell another call. I refer to this in my daily emails as “Covered Call Return (if assigned).”
Execution of a Covered Call
To execute a Covered Call (sometimes called a Buy-Write), you can simultaneously buy the stock and sell the call, or you can buy the stock first and then sell the call. Because both stocks and options are constantly moving, I give you recommended net prices.
If the stock is trading 25, and the call option is $1, you would buy the stock at 25 and sell the call for 1.00. The sale of the option represents a credit to you in your account, so you pay 25 for the stock, take back in 1.00, so the net price is 24 (25-1=24).
If the stock goes up or down slightly, the option will also, so I will give you a net price as a target. It really doesn’t matter if you pay 25 and receive 1.00 or if you pay 25.10 and receive 1.10--the net price is still 24.
As you can see from the examples above, this is a great way to create yield in your portfolio and lower your stock’s cost basis. However, this strategy does limit your upside potential.
For every 100 shares of stock you are long, you should be short 1 call, as the stock position “covers” the short call.
I strongly encourage you to execute covered calls/buy-writes if you have significant holdings focused in just a couple of stocks as it lowers your risk and creates yield.