Covered Call
Description
Writing
a Collar Covered Call is the most basic of income strategies, it is very
effective, and can be used by novices and experts alike.
The
concept is that in owning the stock, you then sell an Out of the Money call
option
on a monthly basis as a means of collecting rent (or a dividend) while you
own
the stock.
If
the stock rises above the call strike, you will be exercised and the stock will
be sold. But you make a profit anyway. (You are covered because you own the
stock
in
the first place).
If
the stock remains static, then you are better off because you collected the
call premium. If the stock falls, you have the cushion of the call premium you
collected.
On
occasion, it is attractive to sell an In the Money or At the Money call while
you
already
own the stock. In such cases, the premium you collect will he higher, as will
the
likelihood of exercise, meaning you will end up delivering the stock at
the strike price of the sold call.
Market
Opinion
With
a Covered Call, your outlook is neutral to bullish. You expect a steady rise.
P/L
Profile
When
To Use
This
option is an income strategy.
Example
1. Buy (or own) the stock.
2. Sell calls one or two strike prices out of the money (i.e.,
calls with strike
prices one or two strikes price higher than the stock).
If the stock is purchased simultaneously with writing the call contract, the
strategy is commonly referred to as a "buy-write".
Generally, only sell the calls on a monthly basis. In this way you will cap-
ture more in premiums over several months, provided you are not exer-
cised. Selling premium every month will net you more over a period of
time than selling premium a long way out.
Remember that whenever
you
are selling options premium time decay works in your favor. Time decay is
at its fastest rate in the last 20 trading days (i.e. the last month), so when
you sell option premiums, it is best to sell them with a month left, and do it
again the following month.
Remember that your maximum gain is capped when the stock reaches the
level of the call’s strike price.
If trading U.S. stocks and options, you will be required to buy (or be long
in) 100 shares for every options contract that you sell.
XXXX is trading at $28.20 on February 25, 2011.
Buy the stock for $28.20.
Sell the March 30, 2011 strike call for $0.90.
You pay: Stock price - call premium. $28.20 - 0.90 = $27.30
For
a collar covered call, also buy a put option to cover your
downside risk. The yield would be less, but you would be protecting your
position on the downside.
Benefit
Investor
is able to accrue monthly income on the underlying stock, plus has reduced risk
compared to simply owning the stock.
Risk
vs. Reward
The
risk is that you lose the stock price minus the call premium. The reward is the
call premium you received plus the call strike less the stock price paid.
Net
Upside
A
good income percentage return.
Net
Downside
Loss
of the price of your stock minus the call premium. Capped upside potential if
the stock rises.
Break
Even Point
Stock
price minus call premium received.
Effect
Of Volatility
N/A
Effect
Of Time Decay
Positive
effect. It eats into the value of the call sold. If the stock does not hit the
strike price, you have reduced your original cost of buying the stock with the
option premium you received.
Alternatives
Before Expiration
If
the stock falls below your stop loss, then either sell the stock (if you are
approved
for naked call writing) or reverse the entire position (the call will be cheap
to buy back).
Alternatives
After Expiration
If
the stock closes above the strike at expiration, you will be exercised. You
will
deliver the stock at the strike price, while having profited from both the
option premium you received and the uplift in stock price to reach the strike
price. Exercise is automatic.
If
the stock remains below the strike but above your stop loss, let the call
expire
worthless and keep the entire premium. If you like, you can then write another
call for the following month.
