In a low-return environment, where stocks appear fairly priced, investors may seek ways to generate additional cash flow, or to temper potential future losses. One multi-purpose approach to equity investing is to implement a covered call strategy. By writing call options on securities held in their portfolio, investors can potentially increase their cash flow and secure some downside protection when they are neutral or moderately bullish on the market or on certain securities. Before implementing this strategy, there are several factors to consider, all relating to the ultimate objective the investor is trying to achieve.
A Call Option Defined
One of the benefits to owning stock is that it can be sold at any point in time for the current market price. However, covered call writing provides investors with another selling opportunity. Investors can sell someone else the right to purchase a stock at a later date, in exchange for cash paid today (which is known as the premium). The person selling the security is the writer, and the potential buyer is referred to as the holder. A call option is the contract that gives the holder that right, but not the obligation, to purchase the security at a predetermined price (called the strike price) over a specified period of time. At least 100 shares of a specific security are needed to write a covered call (one option is equivalent to 100 shares).
A Call Option From Start to Finish
To better understand how call options work, imagine that stock XYZ is currently trading at $100. An investor buys an option and pays a $5 premium for a three-month call option to purchase XYZ at a strike price of $105. The investor has now become the option holder. If in three months the stock is selling for greater than $105, the holder will exercise the option, thereby purchasing the stock. If the stock is trading below $105, the holder will simply let it expire. Thus, the call option holder's maximum loss is equal to the cost of the option, $5, but the potential gain is unlimited.
On the opposite side of the transaction, the writer of the option receives the $5 premium. If in three months, XYZ is trading above $105 and the option is exercised, the writer will sell the stock to the option holder for $105. The writer will recognize a $5 gain on the holding, the difference between the $105 received and the $100 value at the time the option was written. Taking into account the initial $5 premium, plus the gain on the holding, the maximum profit to the writer is $10. However, during those three months, stock XYZ could fall to zero, resulting in a loss of $95. Thus, from the perspective of the writer, the maximum gain is $10, but the maximum loss is $95.
The chart below presents some of the possible profit and loss scenarios from the perspective of the option writer and the holder, as compared to an investor in the same market environment who expects stock XYZ's value to rise in the long term.
Although the writer faces the risk of a higher potential loss, a covered call strategy typically would be implemented when the writer does not foresee a significant change in the price of the security during the allotted time frame. The writer would ideally want the stock to stay relatively consistent, and continue to generate additional income through the premiums. There are, however, several considerations to bear in mind when executing this strategy.
Implementation and Pricing
For investors who own a portfolio of individual stocks, a call option can be written against one or several of these holdings. Alternatively, a call can be written on a broad market index that is highly correlated with the basket of individual stocks, such as the S&P 500 Index.
There are also two main styles of options, American and European. Most of the time, options are European-style, which means they can only be exercised at the expiration date. American-style options can be exercised at any time up until expiration.
Options expirations can range from a week to over a year; however, shorter call options allow for greater control and can potentially increase annualized returns. Within the course of a year, the more volatility there is in the stock, the greater the potential for annualized returns; however, for an option with a longer time frame, the stock owner may lose out on capitalizing on this volatility.
Investors writing call options must decide how far from the current market price the strike price should be. Determining the strike price relates to the concept known as "moneyness," which describes the intrinsic value of an option in its current state and informs option holders whether exercising it will lead to a profit. Terms related to moneyness include at-the-money, out-of-the-money, and in-the-money.
At-the-money means the strike price equals the underlying price. Writing call options at-the-money is often implemented by investors who have already held stocks for a long period of time, and thus have already seen significant appreciation on the stocks. Therefore, if the option is exercised and they sell the stock, they have already realized a gain over time, in addition to the premium received for selling the option. On the opposite side of the transaction, the holder of the option would break even upon exercising the option, and only lose the premium.
When the strike price is above the underlying price, it is out-of-the-money. In this scenario, the option holder would let the option expire to avoid suffering a loss. Premiums received are lower for these options. Because the writer has set a higher strike price, the holder is not going to pay as high of a premium, as it may be unlikely that the stock will reach the higher strike price by the time of expiration. Therefore, the further out-of-the-money the price is, the less premium the writer will receive; but by continuing to hold the stocks, there is potential for upside.
Conversely, in-the-money indicates that the strike price is below market price. The option holder would likely exercise the option and realize a gain. The writer will likely receive a larger premium, especially if the expiration is set for a shorter time frame. In this case, the writer's objective is that a higher premium is more important than price appreciation (or upside) down the road.
Ultimately, strike price is determined by how much income the writer is trying to receive, versus hedging against a downside. The writer must decide what is more important, and whether he or she wants to continue holding the stocks.
Settling an Option
From the perspective of the option writer, there are several actions that could occur when exiting a covered call trade. The two most common outcomes are: the call expires worthless and the writer retains the underlying stock; or the call is exercised and the seller delivers the shares of the underlying stock to the option holder.
It is possible that if the call option is in-the-money at expiration, the seller can close out the call option by buying it back or settling it in cash, therefore retaining the underlying position. The writer can also roll forward the call option, buying out the current one and issuing a new option with a new expiration date. But in most cases, the option either expires or is exercised.
Why Implement a Call Option Strategy?
Common motives to using a call option strategy include:
As previously illustrated, writing call options generates income via premiums received from the buyers of the options. The amount of income produced depends on several factors surrounding option pricing, such as time to expiration and how close the strike price is to the current market price. The strategy implemented can be altered over time. For instance, if the market declines rapidly, an investor may prefer to allow more upside potential, thus writing call options further out-of-the-money. There is no one best strategy to generate income. It merely depends on the investor's goals and objectives.
Part of Structured Sale Program
Investors with concentrated stock positions might consider selling a series of call options with strike prices equal to the prices they would be willing to sell the position at. This strategy will generate additional income for the investor while waiting for the asset to reach a target price.
The premium received from writing the option reduces downside risk as it provides a cushion in case of a decline in the asset's price. For investors who write calls and use the premium income as cash flow, the downside protection is a muted point; they are still going to suffer that downside loss because the income has been spent.
Writing call options is one multi-purpose approach to equity investing. However, there are several things to consider before implementing a covered call strategy, specifically related to the goals and objectives the writer is trying to achieve and how much upside he or she is willing to give away.
A covered call strategy is one way for investors to generate additional income, and tends to work more favorably in a neutral to moderately rising market. The call option premiums can also provide modest downside protection by partially offsetting losses in the underlying holding. For investors on the hunt for ways to generate additional cash flow from their equity portfolio, a covered call strategy could be the solution.