How Stock Options Work Series: Covered Call Writing

Covered Call Option Writing is the subject of this edition in a series on how to trade stock options for income, hedging or pure speculation (see How Stock Options Work: Puts and Calls for intro).  As outlined in my introductory article, a call option grants the holder the right to exercise the option when a stock is “in the money” after the call seller had captured a premium for initiating the transaction.  The call option owner (for all practical purposes) then captures the difference between the current share price and the strike price times 100 since an options contract controls 100 shares.

What is a Covered Call?

In the case of covered call option writing, the investor holds 100 shares of the underlying stock for each option sold.  If you own 100 shares of corporation XYZ trading at $50 per share and sell 1 Call Option Contract with a strike price of $60 and January expiration for $500, as long as shares are below $60 upon expiration in January, you’d keep the $500 because the contract would expire worthless.  If shares move past $60 and the option holder exercises the option (which they generally do at the very last moment, unless there’s a dividend date in play), you can either buy back the option or when exercised, your shares will be unloaded at $60, regardless of where the stock is trading.

Covered Call Option Writing Example – Real Life: Apple

Here’s an example I actually employed with Apple earlier in the year (and I continue to roll the same position as Apple shares continue to appreciate). Note that even though Apple shares DECLINED during the period of the transaction, I actually made money! $600 in 3 months time for holding a stock I wanted to hold anyway.

Bought 100 shares APPLE (AAPL) at 94.6 = $9460 Outflow

Sold a Call with April09 Expiry 110 strike for 11.30 = $1130 Inflow

Closed out Call (bought back) for $120 = $120 Outflow

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Purchase ($9460) – Current ($9050) = $410 loss on shares

Option Inflow ($1130) – Outflow ($120) = $1010 gain on option

Net Gain of $600 in 3 months when shares declined!!!

When shares move in the right direction, such as the move from when this was first published in Feb09, the gains are astounding.  You can get both the capital appreciation AND the option income.

The details of the initial article: Apple Covered Calls

Benefits of writing covered calls

Selling covered calls works out great in a flat or moderately declining market. The investor captures income from the sold calls while holding the underlying stock that they want to hold anyway.

Tax Benefit Strategy – Let’s say you’re sitting on a huge gain on shares of a particular stock and it’s September. For tax reasons, you don’t intend on selling the shares until next tax year to avoid having to pay taxes next April. You’re resolved to hang on to the stock into the new year whether it moves up or down. So, why not sell a covered call with January expiration? In addition to the capital gain you already have and any additional gains, you can guarantee yourself the income from the sold call as well. If the share prices have run up significantly, an options contract is going to carry a nice premium for income.

If the stock moves past the strike price, it’s trouble right? Well, only if you sit on your hands – and even then, you’ve just reached your max gain, but you still made money – don’t we all wish we had that problem! You can always “move the chains”. This is what I’m doing now with Apple shares since they’ve almost doubled from when I first began this strategy. As long as there’s still some time left on the option, the holder at the other end isn’t going to exercise it because they’re leaving money on the table. There is plenty of “time premium” left on the option. They will ride it out.  For full disclosure, I’ve been selling covered calls against Apple shares for some time now and at this point, shares have risen so quickly that the sold call is actually in the money now.  I have a Jan 160 call outstanding against my 100 shares.  But that’s OK!  I’m sitting on a $7000 gain on the shares and I’ve made a few thousand dollars now selling covered calls on the way up.  And what happens between now and January?  Who knows – read on…

What do I mean by time value being left? Take a look at Apple as of 9/11/09.  Share price is 172.  The January 160 strike Call is 21.1, which means it’s worth $2100.  The difference between 172 and 160 is 12.  So, 12 (or $1200) is the intrinsic value (this is easy to calculate yourself).  However, 21.1 minus 12 is 9.1.  There’s $910 in extra value left on this option.  If the holder exercised the 160 Call that I had sold, they’d be leaving all that time on the table, and I’d be given a free $910 today because I could just enter into the same exact position again.

You get Paid to Wait Around and do Nothing – With $910 of time value on the option and about 5 months to go until expiry, (this is a rough calc), I’m making about $910/5 = $182 per month for riding it out.  The risk/reward toward January is such that a holder of that call option just might get around to exercising it though.  If Apple shares are at 200 and there’s only $100 left in time value, they’ll give up the $100 to capture the $4000 gain (200-160)*100.  So, that’s why I need to keep my eye on that position toward the end of the year, but for now, I’m just letting it ride.

What are the Risks of Covered Calls?

There’s no free ride.  If there were, everyone would be doing it and market equilibrium being what it is, any easy gain would quickly be wiped out through arbitrage.  Some obvious and not so obvious risks include the following:

• You need to buy 100 shares of stock to be fully protected with a covered call.  This puts many stock plays out of reach of investors.  With Google shares in the stratosphere, do you want to be dropping $50,000 to start a covered call position?  There are cheaper stocks and there are ETFs as alternatives (see this list of ETFs with their mid-year performance for some ideas).
• You shares can decline. While obvious, if you weren’t doing a covered call strategy, perhaps you would have purchased only 30 shares of something.  Now you’re buying 100.  Keep in mind that you won’t lose “as much” money because your stock losses are offset by the option premium you received.  However, to write another call option once your shares have already taken a haircut requires you to distance yourself from the purchase price emotionally and sell another call for what might be a net losing position.
• You CAN have your shares called away. This can happen at any time.  While it’s unlikely to occur with a lot of time value left on the option for the reasons I mentioned above, you do have to engage in a little dance with risk/benefit and perhaps close the position yourself.
• Fees – Not only do you incur a trading commission each time you sell a new call option, but if your shares are exercised out from under you, you can incur significant fees as well; plus you need to buy back shares again if you want to start over and then you’re subject to the Wash Sale Rule.

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Tagged as: Covered Call Writing, Selling Call Options