Covered Call Options: Simply Understood

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Have you accumulated a significant position in a single company’s stock, either through your employer or a major investment? Have you been considering ways to diversify your holdings away from one of your big winners? Are you seeking to retire soon and looking to reallocate large equity positions in your retirement or other brokerage accounts? Perhaps you’re looking for ways to enhance yields on dividend-paying stocks, or are simply looking for downside protection while capping your upside for a period of time. 

Such situations might benefit from a covered call writing strategy. Known as one of the most conservative of options strategies, it allows you to generate income for your portfolio while committing to selling your holding at a predetermined sales price at a specified time in the future. As such, it can be a powerful method for putting your cornerstone positions to work or for divesting an investment over time.

Here at the Bradford Pine Wealth Group, we believe that knowledge is power, and we want clients to be educated about the investment management strategies available to them. Interested in learning more about writing covered calls? Read on to find out about how this strategy works and whether it might be suitable for your portfolio.

 The Basic of Writing Covered Calls

When you buy a call option, you are purchasing the right to buy a specific number of shares of stock at a pre-determined price, or strike price, and expiration date. The price you pay is called the premium, and you can decide whether you want to buy the shares or not.

On the other hand, when you sell, or write, a call option, you are selling the right for another person to buy a certain amount of stock from you at this agreed-upon price and time. If the option is exercised, you would be required to sell your security at the strike price.

Selling the option is known as writing a call option, and owning the security for which you’re writing calls indicates that the position is covered. In other words, you would not have to go out into the market to buy the security if the option you sell is exercised.

The Options Clearing Corporation (known as the OCC) is the central clearinghouse for most options trades. This means that the OCC is the buyer of all options written and seller of all options purchased. Investors are thus able to deal directly with the OCC instead of finding counter-parties to buy or sell their options. This provides a higher level of stability for the market and simplifies the transaction process. 

How does it work?

The mechanics of writing call options are best illustrated through some examples.In our first case, suppose you own a large position in the fictitious BradPine Corp (BPC), which is currently trading for $30 per share. You believe that the price of BPC will remain at about $30 or even fall slightly for a period of time. While you’re happy to hold onto the position, you decide that you would be willing to sell some of it, perhaps to generate additional income for your account or to diversify your portfolio. As such, you decide to write a call option on 1,000 of your shares. When you sell this option, you enter into a contract which may require you to sell these shares at a predetermined price and expiration date. This would occur if the option is exercised.

Suppose you and your advisor choose a strike price (the price at which you’ve agreed to sell the shares) of $33 and an expiration date (the date the contract ends) in four months. Let’s presume this contract commands a premium (or price) of $4, payable to the seller of the call option(in this scenario is you). As mentioned, the OCC, in its role as a clearinghouse, is the entity with which this transaction would occur. The final buyer of a given call option likewise purchases it from the OCC, instead of, say, purchasing it from you.

To summarize, in this scenario the stock is trading at $30, the strike price of the option is $33, the premium is $4 per share, and your position is covered by the 1,000 shares you own. So, you receive $4,000 in exchange for your promise to sell 1,000 shares at $33 in roughly four months if the option is exercised. If the stock price is below $33 at the end of the contract, the option will in most cases expire worthless. In this situation, you would keep your stock and the premium of $4,000, minus any fees. If the stock price is above $33, the option may be exercised, meaning you would need to sell the 1,000 shares at $33 regardless of the current share price and once again you would keep the premium of $4,000, minus any fees. You might also incur fees in the sale.

In a different scenario, let’s presume that you hold the same beliefs about the price projections of BPC as before. But in this situation, you would like to try to diversify your portfolio and add even more downside protection. In this case, you could keep the four-month expiration date while choosing a strike price that is closer to the stock’s current price, which increases the probability that the option will be exercised. Let’s say you are willing to agree to a strike price of $31, instead of $33. As a result, the premium you receive would be higher than the $4 from the above example, and might be closer to $6 or $7. This occurs because your strike price is closer to the current share price of $30, which means the option is more likely to be exercised. As a result, the market demands a higher premium.

Understand that these are fictitious numbers created for the purpose of providing an example. Premiums will fluctuate depending on many factors, and transaction costs may be significant and should always be taken into account.

Where did these numbers come from?

Choosing a strike price is part of what allows you to tailor the covered call writing strategy to your individual needs. If you are looking to divest the position and/or give yourself more downside protection, a strike price closer to or below the current price can be chosen, which brings a higher probability of sale. On the other hand, if you’d like to increase your odds of hanging onto your shares while generating income, you can choose a strike price further away than the current price, which will command a lower premium and thus provide less downside protection.

Premiums are determined by the market. They are based not only on the strike price, as noted above, but on several other factors, including the length of the option contract (also known as “time value”), the volatility of the security, and the intrinsic value of the option (whether the stock is currently trading above or below the strike price).

While the premium is a price generated by the market, your selected strike price and contract period should be chosen with the guidance of an experienced advisor.

What happens after I sell a covered call option?

Generally, call options are exercised if, at the expiration date of your contract, the stock price is higher than the strike price. If the stock price is below the strike price, in most cases you would not be obligated to sell your shares and the option would expire worthless. In this case, you would keep the premium received minus any fees charged and keep your shares.

As mentioned, options can be exercised before the expiration date. I recommend that you speak to your advisor about the particulars that may apply to your individual situation.

What happens if you decide that you would rather not remain in the contract? You do have the ability to buy back the call option before the contract’s expiration date. This means that you would purchase a contract to close, which cancels out your existing agreement. It is important to note that this strategy involves additional commission charges and could generate either a profit or a loss for you. Again, if your shares are called before the expiration date and before you buy back the option, you would still be obligated to sell them.

Key issues to keep in mind

As you may have gathered, writing a covered call to open is far different from placing a limit order on common stock, which executes automatically when the stock price reaches a certain level. In the case of writing a call option, there are many factors that determine whether your shares will be purchased. These include not only the share price but the transaction costs and premiums faced by the holder of the call option. Whether your shares are called is also, to some extent, random. If an investor who holds a four-month call option (say, for 1,000 shares of BPC at $33) chooses to exercise their right to purchase those shares, the Options Clearing Corporation (OCC) would fulfill the transaction by selling the investor 1,000 shares of BPC at $33. The OCC then needs to close the transaction. In order to do this, the OCC finds an investor who sold, or wrote, the exact same contract. This is done through a combination of random matching and other equitable methods.

Remember that you should not write covered call options unless you are willing to commit to the sale of the shares which cover the call option. If the price of your holding shoots up over the strike price while the option is open, your upside potential is limited by the strike price you’ve settled on plus the premium your option generated minus any fees.

Investor Suitability

Covered call writing is the only options strategy that can be utilized in both IRA and taxable brokerage accounts because it’s known to be conservative relative to other options strategies. Covered call writing is a suitable strategy if you have an equity position that is expected to fluctuate slightly around its current price. If you think the price will either rise or fall significantly, you may want to consider other ways of protecting or diversifying your portfolio.

That being said, writing covered calls can be a good way to slowly divest a position at prices you’re comfortable with or to generate income on a position that trades sideways for a period of time. Especially if you’ve had a long history with a stock, it can be difficult for emotional reasons to sell a large chunk of it or wait for the market to hit a price you find acceptable. Writing covered calls allows you to test the waters with a set amount of stock and an agreed-upon price.

It is important to note that writing covered calls does require you, as an investor, to take a stance on your expectations for the future stock price. Namely, you should expect that the price will remain about the same or fall slightly, and you must be willing to sell the stock at your chosen strike price. Additionally, you must be willing to accept the possibility that you may have to sell your shares before the expiration date, and I recommend that you speak to your advisor about how this could happen. However, please note that if the share price goes above the strike price during the contract period, it does not necessarily mean that the option will be immediately executed (A covered call does not act as a sell order once the share price goes above the strike price). Finally, this strategy requires that you hang onto the risks inherent in holding an equity position; that is, you must be willing to accept that the stock price may go to zero. The premium you receive will provide some downside protection.

As with any investment, make sure that if you choose to utilize an options strategy, it meets your goals and needs. Options can be used to leverage their investment capital or for diversification, income generation, or to hedge against potential losses.  Make sure you understand your investment strategy, as some strategies are primarily speculative and others primarily defensive. You should know how the strategy works, what the objective is, how your stock holdings are utilized, the scope of potential losses, the appropriate strike prices and expiration dates, and whether the potential for gain outweighs your transaction costs. Remember that by their nature, options involve substantial risk, and are not suitable for all investors. In the covered call writing strategy, your main risk is that the stock price may fall to zero, which is a risk you already face as a stock owner. You also lose upside potential if your stock price should exceed the strike price stated in your contract. This makes covered call writing a conservative strategy relative to other options strategies. Selling covered calls is a different strategy to buying calls. Buying calls could cause you to lose your entire investment through the payment of premiums. When you sell covered calls, you receive money through premiums and agree to sell the shares at a price you are comfortable with. This distinction is important to keep in mind. A booklet titled “Characteristics and Risks of Standardized Options” will be furnished to an investor in order for him or her to begin trading options; it also is available online from the Options Clearing Corporation (OCC) website or you can view their home page at www.theocc.com.

Key Takeaways

It’s important to remember that there is no one strategy that will be suitable for every investor. Under the right circumstances, writing covered calls is a powerful strategy, and I recommend that you educate yourself to see if it’s right for you. However, before you get involved in the strategy make sure you understand the trade-off between capping your upside potential and generating income. Further, be certain that you’d be willing to sell your stock if your buyer executes their right to buy from you. 

Of course, there’s much more to consider before embarking on a new strategy, so I would strongly recommend working with a knowledgeable advisor to see if this could be right for you. The Bradford Pine Wealth Group is happy to help tailor a covered call strategy to meet the specific needs of each client, and we would welcome the opportunity to provide more education on the subject.

 

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, it is essential for all investors to read a copy of this disclosure document. It explains the characteristics and risks of trading with options. 

 Securities offered through Cantella & Co. Inc., Member FINRA/SIPC

Bradford Pine Wealth Group and Cantella & Co., Inc. does not provide legal or tax advice. For legal or tax advice, please seek the services of a qualified professional.

If you are seeking detailed information about rolling over your 401(k) or about managing your IRA, I highly suggest downloading my free eBook, “10 Tips You Need to Know About Your IRA Rollover”. This short book is packed with critical information that will help you make the right decisions about your retirement savings.

Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors

The views and opinions expressed in an article or column are the author’s own and not necessarily those of Cantella & Co., Inc. It was prepared for informational purposes only. It is not an official confirmation of terms. It is based on information generally available to the public from sources believed to be reliable but there is no guarantee that the facts cited in the foregoing material are accurate or complete.

Comments may not be representative of the experience of other investors. Investor comments and experiences are not indicative of future performance or results. Views and opinions expressed in the comments section are the author’s own and not those of Cantella & Co., Inc. No one posting a comment has been compensated for their opinions.

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One Response to Covered Call Options: Simply Understood

  1. George Kokinis February 28, 2011 at 2:48 pm #

    Brad,
    In my opinion, I think this is well written and the terminology is relatively easy to comprehend, especially for a rookie. Of course, now, it all makes sense and it’s great to see it explained in a “nutshell” Thanks for asking.

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