Details of the Covered Call
What does “sell a call” mean? This means you instruct your broker to sell a call at a specific strike price for a specific time duration. You will immediately pocket the premium when the call is sold. Remember that as an option seller you are paid this premium because you take on an obligation to deliver the stock to the call buyer if he exercises the option anytime before expiration. Selling a call against stock you already own is referred to as a “covered call” because your obligation to deliver the stock to the call buyer is “covered” by the stock you already have in your account. You will want to consider carefully at which strike price and for what time duration you will want to sell the your call. In many cases, you will want to sell an out-of-the-money call that will expire with the next month. Why is that? Because you will not likely be called out unless the stock rises above the strike price. Select a high enough strike price and that likelihood is minimized. If the price of the stock is less than the strike price of the option at the time of expiration (the third Friday of the month), then the premium is yours free and clear. What if you are called out? No problem, you sell the stock you already own at a higher price than you paid for it and you get to keep the premium! In fact, some people try to be called out each and every month so that they can make a gain on the stock and collect the premium.
Remember Mary from Phoebe, Craig and Mary? Let's say she had accumulated 1000 shares of the utility stock XYZ. Assume that these shares had an average cost of $11.00/share. XYZ is currently at $12.50/share. She can sell up to 10 contracts of XYZ call options on her XYZ shares (10 contracts times 100 shares/contract equals the 1000 shares she owns). She has no desire to be called out. She keeps an eye on the options tables for XYZ and notices she can sell the next month’s calls at a strike price of $15 for $0.25. She has noticed that XYZ has stayed in a range from $10 - $13.50 for the last 12 months. She concludes that it is unlikely that she will be called out of the stock because it would need to rise above $15. In the unlikely event she is called out, she wouldn’t mind a bit because she would sell her shares for $4 more than she paid for them and keep the premium. Nonetheless, she would rather keep the shares because she enjoys the quarterly dividend and she wants to write calls for income each month. Let's do the math: Sell 10 calls at $0.25. 10 calls x 100 shares/call x .25/call = $250 premium received (before commissions). If XYZ is below the strike price upon expriation: She keeps the $250 and has generated this in about one month’s time If called out: She makes $4000 gain on the sale of XYZ and still gets to keep the $250.
Some Considerations to Think About When designing a covered-call program for income generation would you mind being called out or not? If you don’t want to be called out then you will need to consider selling calls at strike prices that are sufficiently out-of-the-money that they are unlikely to be reached. Remember what we learned in Reading Options Tables: The farther out of the money the less you will receive in premium. So, safer covered calls (that is covered calls that are unlikely to be called out) will generate less premium income than ones with strike prices closer to the current price of the stock. You can increase your premium income for the same strike price by selling calls that are further out in duration (say, for example 2 to 3 months out). This will, of course, decrease the frequency of your periodic income, but each call sale will generate a higher payout in premium. Take a look at an options table for particular stocks you follow and see. What can go wrong? This is brilliant. I can’t lose! Hold on, there are indeed some downside risks to a covered call. There are principally two: Big Upward Price Moves in the underlying stock, also known as Opportunity Loss and Big Downward Price Moves in the underlying, also known as Principal Loss. Opportunity Loss means you got called out, made your premium and capital gain, but could have sold your stock at a much higher price had you not sold the now exercised call. The way to deal with this is to realize you made a good profit, you’ve done well, and do not be greedy. Principal Loss can be a serious problem. We will be designing covered calls with several safety nets in mind to bring you out of the position if the price of your underlying stock plummets. The principal methods we will consider employing are the use of a protective put to generate a Collar or the use of a hard stop-loss on the position. More on that in the Step-by Step Guide. Keep in mind that even without selling calls against stock, the risk for principal loss is always present if you own shares. The premium you receive can at least partly compensate for minor losses in stock value. Many people would never consider owning stocks without selling periodic calls against them for this very reason. One other point to be aware of: you can be called out at anytime during the lifetime of the option if the price of the underlying stock you own rises above the strike price. This can and does happen, but most call outs will occur on the 3rd Friday of the month at the end of the option’s life.
Additional Resources The covered call is a commonly used options strategy and much has been written about it. I can recommend the following link for more information:
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