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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, and if it is not exercised, you keep the shares, and keep the 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.
General strategy: Here are two common ways to employ the covered call strategy:
1) 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).
2) 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.
Investors sell short-term call contracts (usually monthly) against their underlying securities as a means of generating income while owning the shares.
If the stock's price closes higher than the contract strike price on the expiration day, the shares may be called away automatically; meaning they will be automatically transferred from the call seller's account to the call buyer's account.
If the stock's price closes lower than the contract strike price on the expiration day, it is said to "expire worthless," in which case the seller keeps the premium. Keep in mind that if your stock price is falling by $1 every month and the premium you get for the call is $.50 every month, you are net negative (losing money).
- There are lots of ways to hurt yourself with this strategy. Here are two that I have seen:
1. Write the call with a strike price below the cost basis. If your shares are called away, and the premium plus cost basis is not equal to or greater than the strike, you just guaranteed yourself a loss on the position.
2. Write the call and get called away in a non-qualified account (non-retirement). This is especially painful if you have a very low cost basis and high concentration of that stock in your portfolio because it may create unwanted capital gains taxes.
Payoff
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