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Writing Covered Call Options
There are many different strategies when it comes to trading options. Some strategies are very risky, while others can actually help lower overall risk. Writing covered calls is one of those strategies that can help give your portfolio some downward protection.
When someone writes call options, they can either write them “naked” or “covered.” Writing naked calls means that the writer does not own the underlying stock for the options he is writing. Therefore, if the options are exercised, the writer will have to go into the open market, purchase the shares of the underlying stock, and subsequently sell them for the strike price. As you can see, writing naked call options is extremely risky and has an unlimited amount of potential loss.
On the other hand, writing covered calls means that the writer owns enough shares of the underlying stock to “cover” his call options should they be exercised. Therefore, if the options are exercised, the writer can simply sell the shares of the underlying stock that he already owns, for the strike price. With covered calls, the amount of potential loss is limited.
Limiting Downside Risk with Covered Calls
By writing covered calls, you can generate revenue from your stocks and place some padding to protect against downward moving stock prices. Let’s go over a real life example from my own portfolio. First, take a look at the underlying stock, which is Altria Group Inc. (MO):
After purchasing the shares, I wrote 3 contracts worth of call options on Altria to place some padding on my 300 shares of the company:
Take a look at the following figures:
By writing the covered call, I placed a 4.492% padding on my investment in Altria over the life of the call option. Therefore, the stock price has to drop 4.492% before I even begin to lose value in my investment.
Also, if the stock price increases beyond $30.00, before the expiration date, I still earn a profit of $1,392.84, which is a 17.5% return on my investment. Also, since I own the underlying stock, I receive the dividends of the company as well, which is currently $1.64 per share, per year, for Altria.
Downside to Writing Covered Calls
As with anything in life, there are some downsides to writing covered calls:
- Until the call option expires, or you buy back your call options (for the current market price of the options), you cannot sell your underlying stock.
- You limit the upside of your investment, because you are bound to sell your underlying stock at the strike price, if the option is exercised. Therefore, even if the stock price of Altria increased to $50.00, I would still have to sell my shares for $30.00.
While the second downside may seem discouraging, you can buy call options to mitigate this risk of possibly losing out on a huge increase in the underlying stock price. For example, I could buy call options for Altria with a strike price of $35.00 and the same expiration date of January 19, 2013. While I would decrease my padding a little, (by the total cost of the call options) I would keep the possibility of benefiting from a large increase in Altria’s stock price.
Writing covered calls is a great way to reduce risk and generate additional revenue from your stocks. There are many different ways to select strike prices and expiration dates for the covered calls you write. However, as long as the strike price you select is higher than the price for which you bought the underlying stock, you will not have a capital loss if the options are exercised.