CoveredCall

What is a covered call?

  • It's a call option contract sold against underlying shares of a stock
  • It's a tool you can use to hedge your portfolio, and lower your risk
  • It's an option strategy you can use to earn more income from your existing portfolio
  • It's a short-to-mid-term investing strategy you can use to double and triple your yields on new stock purchases

What Is A Call Option Contract?

Each call option is a contract which corresponds to 100 shares of the underlying stock or ETF, or index fund. Selling a call option contract obligates the seller to sell his shares of the underlying stock at a specific, pre-determined price, known as the strike price. The seller receives a premium for selling a call option. This premium can often be worth a higher % yield than the stock's dividend.

The buyer of a call contract has agreed to pay the seller a premium, in order to retain the option to buy the underlying stock at the specific strike price at a future point in time. The buyer may choose to exercise his call option at any time, but, normally, most call options aren't exercised until at or near their expiration date.

When a buyer exercises his option to buy the underlying stock, the seller's shares are assigned, (sold), at the call option's strike price. If a call seller is feeling somewhat bullish about the stock, he may choose to sell at a higher strike price that will give him the opportunity to make an additional profit if his shares are assigned.

Conversely, if a call seller is bearish, and wants to hedge his stock against coming price declines, he'll sell calls at a strike price that is closer to either the current stock price, or maybe even below the current price if he's very bearish, if his original cost basis is lower than the current price.

What makes a buyer want to exercise his call options? When the underlying stock's price rises to or past a price level that is the combination of the call's strike price plus the call premium. See the specific trade example below for an illustration of how this would work.

Step 1 - Finding the Options Chain For A Stock

The place to find options available for a stock is its options chain, which is a list of various expiration months for a stock. Each month has call and put options for various strike prices. Each month's options expire after the close of market on the third Friday of that month. Not every stock has options. Look for the word "Chain" or "options chain" in its listing. For example on the Yahoo Finance page, stocks which have options available will have a link on the left that says"Options". Clicking this will send you to an option chain of expiration months for that stock.

Expiration months have come to be arranged by expiration cycle, which means that each stock has certain months in its cycle. The first two months available are the "front month", or current month, and the next month.

Each stock is assigned a cycle that starts with either the first, second, or third month of each quarter. In addition, there are "Leap" months, which refer to January of the next year, and possibly even 2 years out. Depending upon how much the stock's options are traded, there will be one corresponding expiration month from the 3rd and then 4th quarter which become available as the year progresses. For heavily traded options, there may be more months available simultaneously than for thinly traded options.

Trading Options Basics - How To Read An Option Table

When it comes to trading options, one of the first things to master is reading an option table. Listed below is the January, 2010 option table for Olin Corp., stock symbol OLN. These options expire at the close of market on Jan. 15, 2010.

In this view, the calls are listed on the left, and the puts are listed on the right.

Here's a brief description of what's in each column, from left to right:

Column 1: Symbol: Just like stocks, each option has a symbol. These are the call option symbols.

Column 2: Last Price: Most recent price for each call option.

Column 3: Change: How much each call contract has changed in price during trading day, or most recent trading day.

Column 4: Bid: What price buyers are offering for each call contract.

Column 5: Ask: What price sellers are asking for each call contract.

Column 6: Volume: How many call contracts have traded today, or on most recent trading day.

Column 7: Open Interest is how many call contracts are open for each strike price.

Column 8: The Strike Price for each row of calls and puts is the price at which: the call seller agrees to sell the underlying stock, and the call buyer may buy the stock, depending upon certain conditions, which we discuss in the covered call trade example below the table.

Columns 9 - 15: This information is also listed for each put contract.

Options Table for Olin Corp.

Options Expiring Fri, Jan 15, 2010
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Column 1
Column 2
Column 3
Column 4
Column 5
Column 6
Column 7
Column 8
Column 9
Column 10
Column 11
Column 12
Column 13
Column 14
Column 15
Call Symbols
Last Price for Each Call Option
Today's Price Change
Bid Price=Buyers Offer
Ask Price=(Sellers)
Today's Call Volume
Open Interest = Call Contracts Open
Strike Price - Each Row Calls/Puts
Put Symbols
Last Price for Each Put Option
Today's Price Change
Bid Price=Buyers Offer
Ask Price=(Sellers)
Current Put Volume
Open Interest = Put Contracts
OLNAA.X
N/A
$0.00
$9.00
$9.40
0
0
$5.00
OLNMA.X
N/A
$0.00
N/A
$0.15
0
16
OLNAU.X
$6.70
$1.30
$6.60
$6.90
4
15
$7.50
OLNMU.X
$0.30
$0.00
$0.05
$0.20
3
77
OLNAB.X
$4.00
$0.00
$4.40
$4.60
2
321
$10.00
OLNMB.X
$0.45
$0.00
$0.40
$0.50
10
292
OLNAV.X
$2.62
$0.00
$2.60
$2.70
1
340
$12.50
OLNMV.X
$1.10
$0.00
$1.05
$1.20
3
1,818
OLNAC.X
$1.35
$0.05
$1.20
$1.30
8
898
$15.00
OLNMC.X
$2.30
$0.00
$2.20
$2.40
5
344
OLNAW.X
$0.45
$0.00
$0.40
$0.55
111
409
$17.50
OLNMW.X
$4.90
$0.00
$3.90
$4.10
80
191
OLNAD.X
$0.20
$0.00
$0.05
$0.20
10
944
$20.00
OLNMD.X
N/A
$0.00
$6.00
$6.30
0
138
OLNAX.X
N/A
$0.00
N/A
$0.10
0
483
$22.50
OLNMX.X
N/A
$0.00
$8.40
$8.60
0
11
OLNAE.X
$0.10
$0.00
N/A
$0.15
0
386
$25.00
OLNME.X
$12.50
$0.00
$10.90
$11.20
11
206
OLNAF.X
N/A
$0.00
N/A
$0.15
0
363
$30.00
OLNMF.X
N/A
$0.00
$15.80
$16.20
0
1
OLNAG.X
N/A
$0.00
N/A
$0.15
0
304
$35.00
OLNMG.X
N/A
$0.00
$20.80
$21.20
0
0
OLNAH.X
N/A
$0.00
N/A
$0.15
0
63
$40.00
OLNMH.X
N/A
$0.00
$25.80
$26.20
0
0

Covered Calls At Work - A Specific Trade Example

To further explain how to sell covered calls, let's look at a specific trade example for Olin Corp., (OLN), based on the prices in the table above.

Olin closed at $14.14. on Friday, August 7, 2010. For this example, we'll use 100 shares.

  1. Buy 100 shares of OLN at $14.14.  Cash outlay: $1414.00
  2. Go to OLN's option chain, and look for the next strike price above your $14.14 cost, which is the $15.00 strike price.  The symbol for the Jan. 2010 $15.00 call is OLNAC.
  3. "Sell To Open" 1 OLNAC $15 JAN call contract for the bid price of $1.20, which puts $120.00 back into your account immediately upon trade settlement, (less than 3 days).  Your net cash outlay is now $1294.00.  ($1414.00 less $120.00 call premium).
  4. Collect $.20/share, ($20.00) in dividends while you wait for expiration time to roll around.  This brings your net cash outlay and break-even down further, to $1274.00.

At or near the expiration date, there are 2 possible outcomes:

1. Static: If Olin doesn't rise to or above $16.20, (the $15.00 strike price plus the $1.20 call premium), you'll keep your shares, earning a Static Yield of 10% in 161 days, or 22% annualized.

2. Assigned: If Olin does rise to or above $16.20, your 100 shares will be sold at $15.00, netting you an additional Assigned Yield of 6%, since you'll now pocket the $.86/share difference between your original cost of $14.14 and the $15.00 strike price.

Trade Summary:

Investment Time Period: Approximately 161 days

Initial Cash Outlay:  $1414.00

Static Yield: 10%  (Annualized: 22%)  $140.00

Potential Assigned Yield: 6%  (Annualized: 13%)  $86.00

Total Potential Yield: 16%  (Annualized: 35%)  $226.00

Breakeven Price: $12.94

As you can see from the figures above, in this covered call trade you'd net a call premium that's 6 times the amount of the dividend money you'd receive during this period.  This is another reason why many investors have moved to selling covered calls recently, in this era of widespread dividend cuts.  Simply put, no company can cut your call options, ever.

Chicago Board of Options Trading Floor
Chicago Board of Options Trading Floor

Covered Calls - One of Many Options Strategies

There are many other options strategies that investors use to profit from trading options.  As I noted above, using this combination of stock and option trading to create additional portfolio income is merely one of the many reasons investors choose to sell covered calls.

As with any strategy, there are pro's and con's, and there are reasons for and against the decision to trade options via the covered call:

Pro's: 

  • Increased income yields from stocks
  • Increased downside protection via lower breakeven 
  • Protection against dividend cuts
  • Better Cash Flow/ Lower Cash Outlay
  • Predetermined Maximum Potential Profit 

Con's

  • Timing - Even if stock rises tenfold, the call seller still has to sell his shares at the strike price.  It's possible to miss out on price appreciation.
  • Short Term - If the seller's shares get assigned, he has to find a new stock to buy, as opposed to the buy and hold strategy.  For the inactive investor, this may be too much work. 

Additional Option Trading Definitions

Here are some option trading terms you should know.  I've also listed some websites below, which have bigger glossaries of option terms and useful educational materials.

At-The-Money: A term that describes an option with a strike price that is equal to the current market price of the underlying stock.

Buy-write: A covered call position in which stock is purchased and an equivalent number of calls written at the same time. This position may be transacted as a combined order, with both sides (buying stock and writing calls) being executed simultaneously. Example: buying 500 shares XYZ stock, and writing 5 XYZ May 60 calls.

Buy to Close (BTC): The action of closing out a short option position, such as a covered call.

Day order: A type of option order which instructs the broker to cancel any unfilled portion of the order at the close of trading on the day the order is first entered.

Delta: Measures the change in an option’s price resulting from a price change in the underlying stock.  Puts have a negative range, (-100 to 0), and calls have a positive range, (0 to 100).

Historic volatility: A measure of actual stock price changes over a specific period of time.

Implied volatility: The volatility percentage that produces the 'best fit' for all underlying option prices on that underlying stock. The market’s expected volatility for a stock or index.

In-The-Money: An adjective used to describe an option with intrinsic value. A call option is in the money if the stock price is above the strike price. A put option is in the money if the stock price is below the strike price.

LEAPS/Long-dated options: In English, this means calls and puts with an expiration as long as thirty-nine months. Some equities have two LEAPS series at any time with a  January expiration – Jan. 2010 and Jan. 2011. 

Out-of-the-money: An adjective used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is out of the money if the stock price is below its strike price. A put option is out of the money if the stock price is above its strike price.

Comments 1 comment

Hypersapien profile image

Hypersapien 4 years ago

Good hub. I think selling covered calls is a great strategy.

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