By Eric Reed
A covered call is an investment strategy designed to manage risk. In it, investors take two positions: First, they buy a number of shares in a given company. Then, they sell an equal number of call options on that stock. This position then protects the investor against some losses if the stock’s price declines while also generating income in the short term. Here’s what you need to know to start taking advantage of this technique to lower your portfolio’s risk. Consider enlisting the help of a trusted financial advisor as you strategize your investment options.How a Covered Call Works
A covered call is when investors take two simultaneous positions. They buy a number of shares of stock, then sell call options on an equal number of shares in that stock.
For example, take a sample company ABC Corp. An investor building a covered call out of this company’s stock would open a long position on ABC Corp. shares by purchasing those shares, while taking an equal-but-opposite short call position on ABC Corp. options by selling those option contracts. The seller of a call option is sometimes referred to as the the “writer” of the call option.
The resulting position might look like this:
In a call option, the party who buys the option has the right, but not the duty, to purchase the underlying asset at a set price on a given date. The writer of the call option has the obligation to sell that asset if the buyer exercises his option. In return, the buyer pays a fee for the contract.
Under a covered call, an investor buys a number of shares and then opens a call contract covering those same shares. This mitigates the risk of loss on the investor’s initial stock purchase, because no matter what happens they keep the fee which they made by selling the option contract. If the stock price goes down, any losses will be partially offset by this fee. However, this caps the investor’s potential gains off that stock purchase. If the share price hits the option contract’s price, the investor will be obliged to sell at that price no matter how much higher the stock goes.
Meanwhile, the call position is hedged by the simultaneous purchase. No matter how high the stock rises, the investor has already purchased the stocks that may need to be sold. The expenses for that contract are fixed up front.A Covered Call in Action
To understand how this works, let’s look at our example in action. Our investor might take the following position:
In this position our investor now holds 100 shares of ABC Corp. bought at $10 per share. This is a long position; if the stock price goes up, money is made by selling those shares.
Our investor also holds a short position on a call option for 100 shares of ABC Corp. stock with a strike price of $12 per share. This means that in six months, the buyer has the right to purchase 100 shares of ABC Corp. stock from our investor for $12 per share.
Now, three things can generally happen from here:
In this situation, our investor will lose money on the long position but offset losses by the fee they made selling the option.
For example, say that ABC Corp. declines to $8 per share. Ordinarily this would mean our investor would lose $200 (100 shares of ABC Corp. times a $2 per share decline). However, in this case, our investor would only lose $150:
Sale price ($8/share) – Initial purchase price ($10/share) + Contract fee ($0.50/share) = $1.50/share effective decline.
Instead of losing $2 per share, the covered call guaranteed our investor at least $0.50 per share in profit. They lose $1.50 per share, for a total loss of $150.
This is the best case situation for the investment strategy of writing covered calls. The investor makes a profit by selling a long position and also keeps the fee made by selling the short position on the option contract.
For example, say that ABC Corp. increases to $12.25 per share. The option contract expires “in the money” and the buyer calls it in. Our investor sells his or her shares of ABC Corp. to the buyer for $12 per share. Although this is less than could have been made on the open market, our investor has still made a greater profit because the option contract fee has effectively inflated the value of each share:
Sale price ($12/share) – Initial purchase price ($10/share) + Contract fee ($0.50/share) = $2.50/share effective increase
With the fee included, our investor has effectively sold this stock for $2.50 per share. They make $250 off this position even though, at $12.25, 100 shares of ABC Corp. are only worth $225 on the open market (which is the market that securities go to after being on the primary market).
This is, arguably, the biggest risk to a covered call position. In this case the investor loses the potential for profit, and in some cases the loss can be substantial.
For example, say that ABC Corp. has a phenomenal quarter and the price of its shares shoots up to $18 per share. The option contract expires in the money and the buyer calls it in. In a standard long position, our investor would stand to make $800 off the investment (100 shares of ABC Corp. at a $8 per share increase). However, because of the covered call the person is required to sell the stock for $12 per share, limiting gains to the same $2.50 per share profit shown above.
Our investor will make $250 off this position, less than a third of what could have been made off a simple long position on ABC Corp. stock.Covered Calls Summed Up
In a nutshell, the covered call is a strategy for risk mitigation. In it, an investor is guaranteed to make a minimum amount of money off of his investment. Even if the stock goes down to zero, he still keep his fee from selling the options contract. However, the tradeoff to this position is that the investor caps the amount of profit they can possibly make. A covered call’s maximum gain is equal to the strike price gains in the option contract plus the fee from selling that contract.
This is a strategy generally used by investors who expect relatively little movement in a stock. If the price goes up by a little, the investor can compound his profits by pocketing the contract fees. If the price goes down by a little, the investor can at least mitigate the loss.
Otherwise, a covered call may not be the right fit. If you think a stock is poised for serious decline, the fees of a covered call will not significantly reduce your losses. A pure short position may be the better choice. If you think the stock may go up significantly, a long position will keep you from missing out on substantial gains.The Bottom Line
A covered call is a risk-mitigation strategy in which the investor buys a number of shares, then sells (or writes) a call contract against those same shares. By collecting the fee for selling the contract the investor guarantees a minimum amount of gain from the shares although at the expense of capping their maximum possible profits. This investment technique is sometimes advisable for people who do not expect much share price movement.Tips for Investing
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