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Covered call

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Payoffs and profits from buying stock and writing a call.
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Payoffs and profits from buying stock and writing a call.

A covered call is a combination of owning shares of a stock or other securities and selling (or writing) a call option on those shares in corresponding amounts. It has essentially the same payoffs as a short put option on the stock, and thus should have essentially the same price (or premium) as that of a short put. A covered call strategy both reduces the down side risk of stock ownership and limits the potential return.

Unfortunately, this strategy is often marketed as being "safe" or "conservative," even though the flaws in this marketing logic have been well known, at least since Fischer Black published “Fact and Fantasy in the Use of Options" in 1975. Reilly and Brown (2003) state "to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels." (p. 995)

Contents

Examples

If a trader owns 500 shares of XYZ stock worth $10,000 and sells 5 calls worth $1500 then the first $1500 of decrease in the value of XYZ stock is covered. Meaning the investor does not incure a net decrease in value until after the stock declines by more than $1500. However, the covered call position does not prevent losses should the stock decline by a large amount. This "protection" is offset by the disadvantage of being forced to sell the stock (if called) at below market price or buying back the calls should the price rise above the calls strike price.

Payoffs and profits from a short put.
Enlarge
Payoffs and profits from a short put.

Sometimes a covered call is initiated without already owning the underlying stock. If XYZ is trading at 33, and the July 35 call is trading at $1, then one can simultaneously purchase 100 shares of XYZ and sell one call. This requires a net outlay of $3200 compared to $3300 to just purchase the stock. The first $100 ($1 per share) of decline in the stock price is covered by the premium received for the call. Thus the break even point of this transaction is a stock price of $32. Anything higher results in a profit. Anything lower results in a loss. The upside potential for the above is limited to a maximum of $300 (the $100 received for selling the call and $200 for the increase in the share price to 35) a return of almost 10%. The investor does not participate in any further upside as the call requires the investor to sell at 35.

Marketing

The marketing of a covered call strategy as a safe investment involves a change in comparisons: if the stock price decreases the covered call writer will profit - compared to someone who only owned the stock. If the stock price increases the call writer will profit - compared to someone who didn't own the stock.

Another term for the covered call strategy is a "buy-write" strategy, in that the investor buys stocks and writes call options against the stock position.

According to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005), two developments have enhanced the interest in covered call strategies in recent years: (1) in 2002 the Chicago Board Options Exchange introduced the first major benchmark index for covered call strategies, the [CBOE S&P 500 BuyWrite Index (ticker BXM)], and (2) in 2004 the [Ibbotson Associates] consulting firm published [a case study on buy-write strategies]. Many new covered call investment products have been introduced since mid-2004.

Examples of Covered Call Investment Products

References

External links

 

From Wikipedia, the Free Encyclopedia. Original article here. Support Wikipedia by contributing or donating.
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