A Covered Call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income. For example, let’s say you own 100 shares of fictional stock XYZ, which is currently trading at 25. You then theoretically sell one XYZ January 26 Call (expiring 1/18/2014) for $1 for each of your 100 shares.
Let’s take a look at a few scenarios for this trade:
- In this scenario, XYZ shares trade flat for the next month and the stock stays below the 26-strike price. At this point, the options you sold will expire worthless, and you will have collected your full premium of $1 per share ($100). Thus you will have created a yield of 4% in one month’s time.
- In this scenario, XYZ shares fall to 24. At this point, the options you sold will expire worthless and you will have collected your full premium of $1 per share ($100). However, your 100 shares of XYZ will have lost $100 of value. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls against your stock position.
- In this scenario, XYZ shares fall to 23. At this point, the options you sold will expire worthless and you will have collected your full premium of $1 (or $100). However, your shares of XYZ will have lost $200 of value, making you down $100 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
- In this scenario, XYZ shares rise above 26. At this point, the owner of the 26 calls will exercise his right to buy the stock from you. This will leave you with no position. However, you have collected your $1 (or $100) from your call and your stock position has appreciated another $100. You are up $200 on this trade and have created a yield of 8% in one month’s time. At this time, you can move on to another trade or go out and buy the stock again and sell another call.
Execution of a Covered Call
To execute a Covered Call, or sometimes called a Buy-Write, you can simultaneously buy the stock and sell the call, or you can buy the stock first and then sell the call. Because both stocks and options are constantly moving, I will give you a recommended net price.
If the stock is trading 25, and the call option is $1, you would buy the stock at 25 and sell the call for 1.00. The sale of the option represents a credit to you in your account, so you pay 25 for the stock, take back in 1.00, so the net price is 24 (25–1=24).
If the stock goes up or down slightly, the option will also, so I will give you a net price as a target. It really doesn’t matter if you pay 25 and receive 1.00 or if you pay 25.10 and receive 1.10—the net price is still 24.
As you can see from the examples above, this is a great way to create yield in your portfolio.