The Basics of Covered Calls: How and When to Use Them
A conservative but effective option strategy, writing covered calls can benefit both professional market players and individual investors. Also known as covered writing, covered calls involve buying stock and selling calls on a share-for-share basis. Not only does this strategy provide you with an income and dividends, it also ensures capital gains in rising markets; moreover, it provides some protection of capital in declining markets. In this article, you will learn the basics of covered calls.
One of the most commonly used option strategies today, covered call writing is a simple strategy in which you buy 100 shares of a stock and then follow this up by selling a call option with a specified strike price. If this is too hard for you to understand, then let me break down covered calls for you.
Understanding How Covered Calls Work
The best way to understand covered calls is through an example. Before we start with the example, let’s clear some basics. There are two parties involved in every option contract. One party sells (writes) the contract and the other party buys it by going long. In case of covered calls, the writer of the contract agrees to deliver 100 shares of a stock at a specified price, known as the strike price.
Now to the example. Say, the current price of Microsoft’s stock is $140 per share. A contract is written by an investor for 100 shares of Microsoft having a $140 strike price and an expiry of six months. The person who purchased the call option will now be able to buy the 100 shares of Microsoft at the strike price of $140 per share after six months.
Exercising the Covered Call Contract
Like any other options contract, the seller or writer of the covered call will have to sell the stock at the specified strike price if the options contract is exercised; if it isn’t, then the seller or writer will get to keep the stock.
The sold call in a covered call contract is usually out of money (OTM). If the price of the stock stays lower than the OTM option’s strike price, then profit can be made on both the stock and sale of the options contract.
If you are the writer/seller of the covered call and believe the price of the stock will fall, you can sell an in the money call option (ITM) to maintain your stock position. However, the stock must fall below the strike price of the ITM option, or you won’t receive a higher premium from your call option’s buyer.
If the share price of the stock is above the strike price of the option at expiration, then the option’s buyer will be entitled to receive your shares. Generally, investors and long-term traders make use of the covered call writing strategy.
How to Write a Covered Call
By choosing to write a covered call, you agree to sell to another person 100 shares of a stock you own at a specified price and within a specified time period. So, how should you write a covered call contract? You should write it in the following steps:
- Buy a stock in lots of 100 shares
- Every call contract that you write should include 100 shares. If you own 700 shares, then you can write up to 7 contracts to sell the stock. If you want, you can choose to sell less than 7 contracts; this means that you won’t have to part with all of your stock position if the call options are exercised. Continuing with the same example, if you sell 4 contracts, and the stock price is above the strike price at expiration, you will have to relinquish 400 of your shares; however, you will still be left with 300 shares
- Wait till the time the call expires or is exercised. The premium the call option’s buyer pays to you is what you will make money off. For example, if $0.30 per share is the premium, then you will make $120 from the 4 covered call contracts you wrote if the option is not exercised till expiration. You also have the option to buy back the option before it expires; however, this is usually not a good strategy
The Covered Call Options Strategy: Risks and Rewards
The price of the stock you hold can drop and this is the biggest risk associated with covered calls. If the price of the stock drops to zero, then this will be your maximum loss. Following is the formula to calculate the maximum loss per share for covered calls:
Maximum Loss Per Share= (Entry price of the stock-$0) + Option Premium Received
Here is an example explaining maximum loss per share. Say, you purchased a stock at $12, and receive $0.30 option premium on the call you sold. In this case, your maximum loss will be $11.70 per share.Your maximum loss from owning the stock is reduced by the money from your option premium.
However, the income from the option premium comes at a cost; it can limit your maximum profit you make on the stock. The maximum profit for covered calls can be calculated in the following way:
Maximum Profit= (Strike Price-entry price of stock) + Option Premium Received
Let me explain maximum profit with an example. Say you buy a stock at $10 and the option premium you receive from the sale of a $11 strike price call is $0.10. In this case, you can maintain your stock position till the time the stock stays lower than $11 at expiration. If the price of the stock goes up to $11.50, you only profit up to $ 11. This mean that your maximum profit will be $11-$10+0.20= $0.80.
Covered call writing can be a great options strategy if you know how and when to use it. If you need some guidance in this, visit my investors club and join today for all of the chat room and personal learning experience.