Sep

29

Covered Call Options: The Gift that Keeps on Giving

Posted In: Stock Market

The covered call is a tactic in which an investor writes (sells) a call option contract while simultaneously owning an equivalent number of shares of the underlying stock. It is most often employed when the investor, while optimistic on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract.
The investor wants to generate additional income from shares of the underlying stock and/or provide a limited amount of protection against a decline in underlying stock value.

Advantages of Selling Covered Calls
• The seller receives money from the sale of the call on the date of the transaction. If the price stays above the strike price the seller will realize profit from the premium and the option will be exercised, resulting in the stock being sold.
• If the price declines below the strike price, the option will not be exercised. The seller will keep the $300 sales proceeds, and will also retain the stock.
• If desired, the seller can buy back the call before expiration. If the price has declined, the seller may wish to reduce the risk that any more variations will occur.

Disadvantages of Selling Covered Calls
• If the stock price rises well above the strike price, the seller misses out on the increase, as the seller’s profit is limited to the premium.
• The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the underlying stock (greater than the premium) will result in a loss on the entire transaction.
• Premium amounts are based on the historical volatility of the underlying stock. A stock with a higher premium will carry greater risk of price fluctuation.
Let’s create an example using Caterpillar (CAT) by going long 100 shares of CAT @ 47 @ and short 1 January CAT 55 Call @ 4.25. The maximum profit is the premium received for the short call option plus the profit to be gained on the long stock. The maximum reward on the option side is $425 (4.25 x 100 = $425). The maximum reward on the stock side of this position is $800 [(55 - 47 @) x 100 = $800]. The total profit on this particular covered call strategy is $1,225 (425 + 800 = $1,225). The maximum risk is limited to the downside as Caterpillar drops in price beyond the breakeven all the way to zero.

The breakeven on a covered call is calculated by subtracting the call option premium from the price of the underlying stock at initiation. In this example, the breakeven is 42.75 (47 @ - 4.25 = 42.75). Caterpillar must drop below 42.75 for the trade to begin to take a loss (not including commissions). The maximum profit will be received if the stock rises to or above 55 and the call is exercised.

On December 24, Caterpillar climbs above $55 per share. If the short 55 call is exercised, 100 shares of Caterpillar will be sold to permit delivery to the assigned option holder. The $425 credit from the option and the additional profit from the sale of the Caterpillar shares bring the total profit on the trade to $1,225.

This strategy generates income because the investor keeps the premium received from writing the call. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

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Article Source: Covered Call Options: The Gift that Keeps on Giving