Option Investor

Covered-Calls 101

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Covered-Calls: How Conservative Are They?

The sale of covered calls is commonly referred to as a low risk approach to stock ownership yet many investors lose money with this strategy. Fortunately, the cause of these losses is not the technique itself and in fact, covered calls can be both conservative and profitable when implemented correctly.

Generally, the covered-call strategy is used in conjunction with shares of common stock held in an investor's brokerage account. The basic concept is to produce additional income from the sale of options, thus enhancing a portfolio's return on investment regardless of the current market trend. Some investors worry about the risk of selling (short) calls but in this case, the options are "covered" because the investor owns the underlying stock. For every 100 shares of stock the investor owns, he can "write" one option contract. In addition, covered calls can be sold against margined stock thus reducing the cash outlay for short-term positions.

When it comes to selecting which call option to sell, most people choose the strike near (at-the-money) or slightly above (out-of-the-money) the current price of the stock. This approach typically offers the best balance between immediate cash inflow and future capital gain. In contrast, more aggressive investors often favor higher strike (deep-out-of-the-money) calls, thus reducing the premium received in exchange for additional upside potential. Those who choose the latter method typically have at least one of the following objectives in mind:

1) They want greater share value appreciation in bullish markets

2) They have a longer-term perspective that involves more distant (option) expiration dates, in order to allow the underlying stock extra time to increase in value.

3) They do not want the stock called away

As an example, a person who purchased a particular stock for $20.00 per share would have a number of alternatives when choosing a covered-call position. Consider the following table, which lists three-month call options on a popular issue in the technology segment.

If the investor expects some upside activity in the stock, he might sell a slightly out-of-the-money strike, such as the $22.50 call, for a credit of $1.85 per contract. If his outlook for the issue was very bullish, he could write a higher strike call, such as the $25.00 option, and receive only $1.15 per contract. Assuming the share value moved higher prior to option expiration, the investor would realize some amount of capital gain (in both cases) in addition to the initial premium received from the sale of the call.

But, how do these positions fare when the underlying asset does not move as anticipated? Since the amount of option premium received is inversely related to the downside risk (established by the cost basis) of the position, the transaction that provides more immediate income will be less affected by a decline in the stock price. In this example, selling a $22.50 call is more conservative than selling a $25.00 call because additional income (which translates to greater downside protection) is generated by the lower strike option. The resultant cost basis of each position is listed below:

Position A - Conservative

Buy XYZ Stock at $20.00
Sell $22.50 Call; Bid = $1.85
Cost Basis = $20.00 - $1.85 = $18.15
Downside Protection = 9.2%
Maximum Profit = 23.9%

Position B - Less Conservative

Buy XYZ Stock at $20.00
Sell $25.00 Call; Bid = $1.15
Cost Basis = $20.00 - $1.15 = $18.85
Downside Protection = 5.7%
Maximum Profit = 32.6%

As you can see, there are many different risk-reward profiles available to the covered-call writer and even when the sold options are some distance "out-of-the-money," the strategy may be more conservative than the outright purchase of the underlying issue. However, many investors reduce the risk of stock ownership further by selling in-the-money options. Let's look again at the table of option prices:

Notice the relatively large amount ($4.30) of premium available at the "deep-in-the-money" $17.50 strike. A covered-call position established through the sale of this option will have substantial downside protection and yet retain a reasonable amount of profit potential.

Position C - Very Conservative

Buy XYZ Stock at $20.00
Sell $17.50 Call; Bid = $4.30
Cost Basis = $20.00 - $4.30 = $15.70
Downside Protection = 21.5%
Maximum Profit = 11.4%

Obviously, there is far greater upside potential in the more aggressive alternatives however readers should note that the maximum profit in Position C occurs with (up to) a 12% decline in the stock price. This characteristic makes the in-the-money covered-call a unique portfolio management tool for stock buyers and considering the recent volatile activity in equity values, some investors may favor a more conservative posture; one that focuses on earning a relatively consistent return and preservation of capital. In addition, a low-risk/low-profit mentality is one of the keys to success in options trading and this strategy can be attractive in virtually any market environment, as long as the investor is not concerned with long-term ownership of the underlying issue.

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