 | |
- close
- close
|
Suggest other news sources for this topic
WIKI ANALYSIS| This article is part of WikiProject Definitions. Consider editing to improve it. View articles referencing this definition. |
A Covered Call is a financial position in which you own an underlying asset, and write, or short a call option on the underlying. In other words, you have sold to the buyer the right to purchase an asset from you, but you also own the asset in the event that they exercise the call option. A quick example would help illustrate the point. You short a call option on 100 shares of Company Z, but you also currently own 100 shares of Company Z. If the call is exercised, you deliver the 100 shares and receive the strike price. Conversely, if it is not exercised, you keep the shares of the company, and you also earn the price you charged for selling the call (often times referred to as the call premium).
Covered call writers should be aware of volatility's effect on their short option position. An increase in implied volatility will make it more expensive in the event that the investor wishes to "buy back" the option prior to expiration.
Covered Call Strategies
There are two common ways to use covered calls:
- Buy-write: A buy-write (or buy-and-write) is the purchase of the stock and immediate sale of the call option. It is the immediate sale of the call that sets this tactic apart from the legging-in strategy. Most retail brokerage platforms offer the trader the ability to enter both orders (long stock/short option) all at once. The index that charts this strategy for the S&P 500 is BXY (see image at bottom).
- Leg-in: Legging in to the covered call means purchasing the stock and in a later transaction selling the call. This tactic implies that the trader can time his/her way into the short option position sometime in the future for a higher profit than if they simply did a buy-write.
What are the uses of covered calls?
Because an investor who takes a covered call position has the underlying asset, in the event the buyer of the call option exercises he can deliver with certainty. Therefore, investors sell short-term call contracts (usually monthly) against their underlying securities as a means of generating income while owning the shares. This allows them to earn money even if the asset value does not increase. For instance, suppose you bought 100 shares of Company X at $10 per share. You then sell a call option for $1 against those 100 shares with a strike price of $12. As long as the price of the stock remains below $12, you get to keep the shares as well as the $1. If the price of Company X stock stays at $10 all the way until the call option expires, then you have generated $1, yet you still own the stock. However, if the stock price rises to $14, then the stock is called away, and you earn only the $12 strike price and the $1 premium for selling the call.
Potential pitfalls of covered calls
A major pitfall of covered calls involves writing the call with a strike price below the cost basis (cost basis means the cost to you of acquiring the shares). If your shares are called away, and the premium plus cost basis is not equal to or greater than the strike, you are guaranteed a loss on the position. For example, you paid $1000 in total for 100 shares of Company X ($10 per share), and you sold a call option on these 100 shares with a strike price of $9 per share. If you do not charge more than $1 for the call option, you are guaranteed a loss in the event they are called away since they pay only $9 per share ($900 total), and you are earning less than $100 for selling the call. If the shares fall below $9, you will suffer a loss since in total you will receive less than $1000, which is the price you paid for the shares.
Payoff
| ||||||
