What Is a Covered Call Strategy?
Risk management is everywhere. When you’re climbing stairs, you face the risk of falling off. But when you hold a railing while climbing, you basically mitigate that risk. That’s risk management for you in the simplest of forms. Let’s get a bit more technical.
Risk management is a process where the risk related to a transaction are assessed with the objective of controlling the probability of its occurrence or minimizing its impact. If you’re looking for making extra-ordinary gains in the world of finance then you have to take risks. However, there are ways to mitigate risk. Derivatives are one of the financial instruments used by financial experts and investors in formulating an effective risk management strategy. The two most basic options strategies used by many investors are:
- Covered Call: This involves holding a long position in a stock and selling a call option of the underlying. This strategy is the focus of the article.
- Protective Put: This involves purchasing and holding a stock and the underlying put option. We’ll focus on this strategy another time.
This article will give you an in-depth knowledge on how the “Covered Call” strategy works. But before going into that, we need to make sure that some of the basics have been covered.
Options – Quick Refresher
As explained in a previous article titled “The Difference Between Stocks and Stock Options”, a derivative has three main features:
- It is a legal contract.
- It derives its value from an underlying. The underlying can be an asset, e.g stock or it can be an interest rate.
- There is a long party, who will buy the underlying, and a short party, who will sell the underlying.
Options, a derivative instrument, are used by many financial experts for hedging risk. Options give the holder the right, but not the obligation, to buy or sell the underlying at a specified price, on or before a specified date. There are two types of options which are as follows:
- Call Options: This gives its holder the right, but not the obligation to buy the underlying at a specified price on or before a fixed date.
- Put Options: This gives its holder the right, but not the obligation to sell the underlying at a specified price on or before a fixed date.
Before moving on, it is highly recommended to read the article “The Difference Between Stocks and Stock Options”, and get yourself familiar with the basics on how options work.
Benefits of a Covered Call Options Strategy
As previously mentioned, a covered call options strategy is the combination of holding a stock along with writing (selling) a call option. The benefits include:
- The covered call position earns a premium from selling the call option. The premium amount is the price of the call option and depends on several factors. These include:
- The time horizon of the call option; the further away the exercise date of the option, the more expensive the option is. For example, an exercise date that is three months from now is more expensive than an exercise date that is only one month away.
- The price of the underlying and exercise price (also known as strike price) of the call option. The lower the exercise price, the more expensive the call option price. For example, if a stock is trading at $45 and the exercise price is “in-the-money” (lower than current stock price) at $43, the call option will be more expensive than one with an “out-of-the-money” (exercise price is above the stock price) strike price of $48.
- The volatility of the underlying asset. The more volatile a stock is (more rapid up and down movement with a higher standard deviation), the more expensive any option will be. This is because there’s a higher probability of the stock increasing and decreasing in value, thus options can increase in value faster.
- Market risk-free rate; higher rates translate into higher call premiums.
- Dividends of the underlying; during dividend payouts, stocks generally fall by the amount of the cash dividends on the ex-dividend date. By extension, this affects call prices as well. The higher the dividend payouts of the underlying, the cheaper the call option.
- Liquidity; the lower the liquidity of the underlying and the options, the more expensive option prices are.
- There is also some downside protection to the seller of the call option (i.e. the one with the covered call position). Because the covered call strategy receives a premium, that amount mitigates the potential downside. For example, if the premium received for the option is $1.50, then the investor will have that amount as a cushion in the case that the underlying decreases in value before the exercise date. The strategy is considered as a conservative one since it minimizes the downside risk of holding a stock.
- The investor not only gets to earn a premium by selling the option but will also be exposed to stock ownership benefits (e.g. dividends and voting rights).
Downside of a Covered Call Options Strategy
- Limited upside; there’s essentially a maximum gain from the covered call position. This is because as the seller of a call option, you enter into a contract to sell the underlying at a predetermined price. And the buyer of the call option has the right to buy the underlying at the exercise price until the expiry date. Therefore, if the exercise price is $43 and the market price of the underlying is $45, it makes sense that the investor with the long call position will exercise the option to obtain the underlying for cheaper; $43. Which means the short call position will lose that $2 gain from the stock appreciation. Although this loss balances out because the covered call position also has the underlying as a hedge against this $2 loss. Therefore, the covered call position will not gain any profits past the exercise price of $43. To sum-up, the short call option position won’t be able to fully benefit from capital appreciation in excess of the exercise price, thus limiting the benefit to the strike price of the option. When the stock price is above the exercise price, this is known as “in the money”.
- Risk of losing ownership of the underlying asset; if the counterparty (long call position) decides to exercise their call option, the stock ownership gets transferred to that option holder.
- Commission costs; all buyers and sellers of option transactions incur commission expenses.
In-the-Money vs. Out-of-the-Money Covered Call
The covered call strategy can be divided into two:
- In-the-money (ITM) covered Call
- Out-of- the-money (OTM) covered call
ITM Covered Call: If you’re looking to earn a normal return on your investment, adopting in-the-money covered call strategy is the way to go. The strike price is lower than the underlying stock and thus the option is in-the-money. The writer of the call option will not benefit from any upside movements in the stock price and his return will only consist of premium received at the start of the contract.
The maximum profit, or target return, is generated by this strategy when the price of the underlying is greater or equal to the strike price of the short call option. Therefore the deeper the short call is in-the-money, the more likely you are to earn the target return. This is called the probability of target return. Additionally, the downside risk of a falling price is minimized due to the decline needed to reach the at-the-money level and the cushion provided by the premium income.
Break-even point is achieved when the price of the underlying is below the strike price by the premium amount. I know this all may be going over your head, but this process will become much easier to understand through a simple example.
You buy 100 stocks for $45 and want to simply make a fixed return on the stock. You believe the stock won’t fall below $43, so you sell (write) a call option with that strike price. This is an ITM covered call strategy because the strike price is below current market price. The exercise date is in a month and the premium of the call option is $3. You net investment is $45 x 100 – $3 x 100 = $4,200. Let’s examine what happens if the price falls or increases.
Scenario 1: Fall in price
Let’s say the stock price falls to between $43 and $45 by the expiry date (example $44), which is above the strike price of $43. The option gets exercised at the $43 strike price, and you are left with no position. Your profit is the premium you received minus the loss on the underlying stock ($3 x 100 – [$45 – $43] x 100 = $100). The reason we use $43 in the equation and not $44 is because when the option gets exercised you effectively sell the stock at the exercise price, which is $43. The $100 profit also happens to be your target return you can make on this investment.
If the price of the stock falls between $43 and $42 by the date of expiry (example $42.30), your profit again equals the premium you received minus the loss on the underlying ($3 x 100 – [$45 – $42.30] x 100= $30). The reason we subtract $45 minus $42.30 this time is because you were left with the stock since it didn’t get exercised.
If the price of the stock falls below $42 at the time of expiry, your position losses money. For every dollar the stock falls below $42 you lose $100. For example, if the stock declines to $40, your loss equals [$42 – $40] x 100 = $200.
The total loss ($42 x 100 = $4,200) occurs when the stock price declines to $0. As you would expect, the probability of total loss with a covered call is almost always zero, but anything can happen, especially with extremely volatile stocks.
Scenario 2: Rise in price
Basically, any stock price above the $43 strike price makes you the max profit, or target return, of $100. The reason for this is because your option gets exercised at $43, you bought the 100 stocks at $45, and you have the $3 premium per stock you received from selling the call. Therefore, the equation becomes: 100 x $3 – 100 x [$45 – $43] = $100.
OTM Covered Call: An out of the money covered call strategy involves holding an underlying stock or asset while writing (selling) an out of the money call option. An out of the money call option is that which has a strike price higher than the current market price of the underlying.
The writer of the OTM call option has the advantage over the ITM call option because of the exposure to some price appreciation. Since the call option is out of the money, the value of the option would be lower and so the premium paid will be lower than the premium paid related to the ITM call option.
The OTM covered call strategy is generally adopted by bullish investors who are expecting price appreciations and are looking to profit from this expectation. The downside of this strategy compared to an ITM covered call is that since the premiums are lower, the scheme will not provide as much protection as the ITM covered call from losses due to fall in price of the underlying. Again, don’t get worried if this is a bitter pill to swallow, since you will have a better grip over the above by reading our simple example below.
You buy 100 stocks for $45. You believe the stock will increase to $47, so you sell (write) a call option with that strike price. This is an ATM covered call strategy because the strike price is above current market price. The exercise date is in a month and the premium of the call option is $0.50. You net investment is $45 x 100 – $.50 x 100 = $4,450. Let’s examine what happens if the price falls or increases.
Scenario 1: Fall in price
Let’s say the stock price falls to between $44.50 and $45 by the expiry date (example $44.60), which is below the strike price of $47. The option does not get exercised. Your profit is the premium you received minus the loss on the underlying stock ($0.50 x 100 – [$45 – $44.60] x 100 = $10).
If the price of the stock falls below $44.50 at the time of expiry, your position losses money. For every dollar the stock falls below $44.50 you lose $100. For example, if the stock declines to $42.40, your loss equals [$44.50 – $42.50] x 100 = $200.
The total loss ($44.50 x 100 = $4,450) occurs when the stock price declines to $0.
Scenario 2: Rise in price
If the price of the stock rises between $45 and $47 by the date of expiry (example $46.30), your profit equals the premium you received plus the gain on the underlying ($0.50 x 100 + [$46.30 – $45] x 100 = $180).
And any stock price above the $47 strike price makes you the target return of $250. The reason for this is because your option gets exercised at $47, you bought the 100 stocks at $45, and you have the $0.50 premium per stock you received from selling the call. Therefore, the equation becomes: 100 x $0.50 – 100 x [$47 – $45] = $250.
Comparing the two different ways to play the covered call strategy, the ITM way will protect the investor more from losses as compared to OTM covered call strategy. On the other hand, the ITM strategy puts a ceiling on the upside potential of the position for the investor as compared to the OTM covered call strategy. Whichever strategy is selected by you, it will entirely depend on your expectations of the price movement of the underlying. If you expect an increase in the price, an OTM covered call strategy will be more suitable. Whereas, if you expect the price of the underlying to decrease or stay flat, an ITM strategy might be more appropriate. The decision also depends on your risk tolerance and what you wish to accomplish from your investing activities.