What is a covered call?

Now that we have a good understand in what options are lets start learning about some of the more lucrative strategies involving options.




Covered Call Introduction
One of the most common strategies is selling or writing call options against a long position in underlying stock. This is also referred to as "covered call writing" (CC). When utilizing this option strategy, the investor is neutral to slightly bullish about the direction the stock will move in the near term. CC writing is considered more conservative than strictly buying and holding stock because the risk is offset by the CC premium earned for selling the option or "call".
There is an option buyer and seller in every option transaction. Using the CC strategy, the owner of the underlying stock is considered the option seller or CC writer. As the CC writer, the investor is willing to limit the upside potential movement in the stock price by selling the option strike price and immediately receiving the option premium which is paid by the option buyer. The seller of the call is then obligated to sell the underlying stock should the stock price move above the option strike price. As you will see there are some very profitable premiums that can be made using this option strategy. But remember, the more profitable premiums also means more volatility in the stock price, thus possibly making it a somewhat risky position.
It is important to note that no matter what happens to the stock price during the option period, the CC writer retains the call option premium. If the stock price drops or stays the same through the option period, the stock owner retains the CC premium and the underlying stock. If the stock price should move above the call option strike price, the CC writer still keeps the CC premium and may have the stock called away by the option buyer. That's o.k., because the CC writer realizes profit from the CC premium and the increase in the stock price minus the stock purchase price. The CC strategy can be a consistent way to realize profits for the stock owner, but it does limit the upside potential should the stock price move upward significantly during the option period.
There is one reason the call option buyer is willing to pay this up-front premium for the right to buy the stock at the option strike price; leveraging investment capital. So, what is the downside for the option buyer? Because an option contract has time value, as soon as a call option is purchased time is eroding that value. In order for the call option buyer to realize profit, the stock price, which affects the option price, must increase prior to the option expiration date or the option expires worthless. Time is working for the call option seller or CC writer, but working against the buyer of that call option.
Call Option Positions
There are a number of different terms that describe the option strike price in relation to the stock price. Lets look at three terms:

In-the-money - This term refers to a call option strike price that is lower than the current stock price. For example, if a CC writer sold a call that is the May $10 strike price against a stock that is currently priced at $12.50, this would be considered an in-the-money call position.

At-The-Money: This describes an option strike price and a stock price that are the same. For example, if the CC writer sold a call that is the May $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money call position.

Out-Of-The-Money: This option position is riskier than in-the-money or at-the-money call positions, but has the greatest profit potential. Because the option strike price is slightly higher than the stock price, a slight movement in the stock price will allow the CC writer to realize a gain with the CC premium and the difference between the call option strike price minus the stock purchase price. The CC premium will not be as large as an in-the-money or at-the-money position, but the combination of the stock price increase and CC premium on a slightly out-of-the-money option generally has the best profit potential.
Some investors purchase a stock and then later make a decision which option to sell or write against that stock. There is more analysis that is necessary in making your selection for which stock to purchase and write a CC against. You can fall in love with a particular stock and continue to write slightly out-of-the-money CCs against that stock, but the combination of stock price increase and CC premium may not be the most profitable investment return. You may also select a stock strictly based on the CC premium returns. This may be risky because the underlying stock may not have the fundamentals to support its current price. Remember, the only way an option investor can lose using the CC strategy is if the stock price drops more than the CC premium realized during the option period. If you invest in a stock with weak fundamentals strictly to realize the high CC premium, the stock may drop significantly (and possibly never recover) during the option period and the CC premium will not offset the stock price loss.
How Do I Identify a Good CC Candidate?
A question that is often asked is, "how do identify a CC candidate"? While you can look at the highest in-the-money and out-of-the-money CC premiums each day, this does not necessarily mean that buying the stock with the highest CC premium percent return is the purchase you should make. There are many fundamentals that must be considered to make sure that your risk versus reward criteria is met.
There are various theories and strategies available for deciding which underlying stock and its associated CC are right for your investment criteria. We would like to outline just a few things that we consider important when making your CC decisions. Here is a list that may assist you when reviewing a particular stock before making an investment in that stock and writing the CC:
First, take a look at the Bollinger Bands/Relative Strength Index (BB/RSI). Is the stock trending up or down? Is the stock at the lower range of the RSI and down toward the bottom BB band?
Once you find a CC candidate that has a stock price toward the bottom BB band and has a relatively low RSI with an upward trend, take a look at the fundamentals of the stock.
Take a look at the profile of the company. What industry and business sector is the company involved in? Is this the type of sector you think has growth potential in the near term? How were earnings for the previous quarter? Take a look at the company summary and see if the numbers meet your criteria.
Two areas that can be reviewed is the profitability and management effectiveness of the company. This number should be positive. If not, you should do more research and find out when they expect to be profitable.
52 week high/low - Is the stock price at the 52 week high or low? Is the stock trending down and could set a new low (this shouldn't be the case if you reviewed the BB/RSI and selected a stock that is currently trending up). What is causing the stock to be at a high or low; good quarterly earnings, rumors, etc.
Price/Earning Ratio (PE) - Does the stock have a PE ratio that is in line with companies in the same industry sector? If not, do a little homework to find out why it has a high or low valuation versus the rest of the industry.
Message Boards - This can be great information or it can steer you in a negative direction. Be careful what you read into message threads, you don't always know the motives of the people posting to a particular thread. There is as much good information as there is misinformation. Rely on the fundamentals and make your own decisions based on your risk versus reward criteria. Nobody knows better than you what you are willing to risk for a pre-determined gain.
Volatility - How Does it Affect Option Premiums?
High option premiums are usually generated by volatility in the stock price. If there is some sort of positive or negative news or other excitement about the company the stock price will be affected, sending the premium up or down. Why are there call options with such high premiums? "More volatile underlying stocks have higher option prices. This relationship is logical, because if a stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay higher prices for the calls--and sellers demand them as well.

"McMillan in "Options As A Strategic Investment"

By having your research pool include stocks that produce high CC premiums you have another angle to find stocks that can possibly help you make monthly and yearly returns that are relatively conservative (compared to strictly buying call options) yet potentially more profitable than simply buying and holding stock. You must still do your own detailed research of the fundamentals of the underlying stock to see if it's a stock you'd be comfortable holding if the stock price drops.
How Do I Write a Covered Call?
To write a CC, you must first own the optionable stock. The CC writer can buy stock in 100 share blocks and simultaneously sell an equivalent number of call options against the underlying stock (what is known as a "buy/write"). One option contract is equivalent to 100 shares of stock. So, if you own 500 shares of a particular stock, you will sell 5 call option contracts.
The writer sells call options against stock that is already owned. This strategy is often referred to as "legging in".
You must get approval from your stock broker in order to write covered calls. Your broker may require you to fill out some paperwork to receive this approval. He or she will also send you "The Characteristics and Risks of Standardized Options" brochure. It is mandatory that prior to trading options this brochure is delivered to you by your broker.
Here are some simple steps to write a covered call:
Identify and fully research an optionable stock that has a CC premium that meets your risk versus reward criteria.
Instruct your stock broker or enter your order through an on-line brokerage account and purchase the stock. You can then enter a call option order to sell a specific number of option contracts against your purchased shares. For example, you could purchase 500 shares and then turn around and sell 5 call option contracts against those shares.
You must specify the month and strike price for the call option contract. Options are available in specific months and at specific strike prices. Here is an example of available strike prices - $5.00, $7.50, $10.00, $12.50, $15.00, $17.50, $20.00, $22.50, $25.00, $30.00 and $5 increments thereafter for stocks over $25.
Option Expiration Day - Expiration day is the third Friday of each month. When you write the CC (sell call options) you have sold a call that expires on the third Friday of a particular month. On this date, your call options will either be called out or exercised (the stock price is above the call option strike price) or the option will expire worthless (the stock price is below the call option strike price).
If your option is called out (exercised) your stock will be sold at the CC strike price. You will keep the CC premium as well as the difference between your stock purchase price and the call option strike price.
If the call option expires with the stock price below the option price, you still own your stock and you keep the CC premium. You can then turn around and write another CC on the same underlying stock.
Commissions - Check with your broker about commissions charged when purchasing stock as well as writing covered calls. You will be charged commissions for purchasing stock, selling the CC and selling your stock if the call option you have sold is called out (exercised). The CoveredCalls.com Calculator takes these charges into consideration when calculating your actual percentage return on your covered call transaction.
Margin - Most brokerage firm accounts, except IRA accounts, allow margin. That means that you can purchase stocks wherein you put up 50% and the brokerage puts up 50%. For the cost of interest charged on your margin account you have twice the amount of purchasing power. If you purchase stock on margin, then sell a CC your percent return is doubled, minus the margin loan interest charge.

Basic overview:
Option Strategy: Covered Call Writing (Own/Buy Stock, Sell Out-Of-The-Money Call Options)

Investor Sentiment: Neutral to Slightly BullishProfit

Potential: Realize revenue if stock price stays the same or moves up to the out-of-the-money (higher) call option strike price and is called out or exercised. The positive side is the option seller realizes immediate profit by retaining call option premium.

Risks: If stock price moves down significantly, the option premium may not offset the loss in stock price.

Drawbacks: Investor loses upside profit potential when stock moves past the call option strike price.


Tomorrow we will talk about where we find the information to determine what is a good covered call as well as another version of this strategy that will limit the downside risk that can occur when a stock price falls.