A covered call is referred to as that financial market transaction in which the corresponding amount of the underlying instrument is owned by the seller of call options, such as shares of a stock or other securities. The strategy is often referred to as a “buy-write” strategy, if the trader buys the underlying instrument at the same time as he sells the call. In equilibrium, the strategy has got the same payoffs as writing a put option.
It is said that these long position in the underlying instrument provide the “cover” as if the buyer of a call decides to exercise then they can be delivered to the him.
Writing a call generates Income
Income is generated by writing a call, that income is in the form of the premium that is paid by the option buyer, and writer will be able to keep this income as a profit, if the stock price remains stable or increases, even though if no call were written the profit may have been higher. The risk of stock ownership is not eliminated. If there is a decline in stock price then the net position will likely lose money.
Since in equilibrium the payoffs on the covered call position is the same as what they are for a short put position, the price (or premium) should similar to the premium of the short put or naked put.
Example
An investor has 500 shares of XYZ stock, which are valued at $10,000. For $1500, he sells 5 call option contracts (in the US, 1 option contract covers 100 shares), thus doing this he covers a certain amount of decrease in the XYZ stock (i.e. only after that the stock value has declined by more than $1500 then the investor would lose money overall). In a covered call position losses can not be prevented, but merely they can be reduced. If there is a drop in stock price, then it will not make sense for the option buyer to exercise the option at the higher strike price since now the stock can be purchased cheaper at the market price, and money paid on the premium of the option will be kept by the seller (writer), thus his loss will be reduced from a maximum of $10000 to $10000 – (premium), or $8500.
Potential disadvantage of Protection
This “protection” has one potential disadvantage and that is that at expiry the investor (option writer) may be forced to sell his stock below market price, or he must have to buy back the calls at a price that is higher than he sold them for.
If the spot price does not reach the strike price before expiration, then the investor might repeat the same process again if he/she presume that stock will either fall or be neutral.
Example
Even if the option writer doesn’t initially own the underlying stock then also a call option can be sold. If XYZ trades at $33 and $35 calls are priced at $1, then 100 shares of XYZ for $3300 can purchased by an investor and for a net cost of only $3200 he can sell one (100-share) call option for $100. A $1 decline in stock price will be covered by the $100 premium received for the call. $32/share is the break-even point of the transaction. Upside potential is limited to $300, but this amounts to a return of almost 10%. (the call option holder will exercise his option if the stock price rises to $35 or more, and the investor’s profit will be $35-$32 = $3). The call option will be allowed to expire if the stock price at expiry is below $35 but above $32, but the investor can still profit by selling his shares. The investor experience a loss only if the price is below $32/share.
To summarize:
Marketing
This marketing strategy is sometimes categorized as “safe” or “conservative” and even “hedging risk” as high income is generated by it and since 1975 its flaws are well known when Fischer Black published his theory in “Fact and Fantasy in the Use of Options”.
According to Reilly and Brown (2003);
“to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels.” (p. 995)
Enhancement in Covered Call Strategies
According to the article “Buy Writing Makes Comeback as Way to Hedge Risk”, in recent years, the interest in covered call strategies has been enhanced by two developments.
Pensions & Investments, (May 16, 2005):
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In 2002, the the first major benchmark index for covered call strategies known as the CBOE S&P 500 BuyWrite Index (ticker BXM)was introduced by the Chicago Board Options Exchange, and
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In 2004, a case study on buy-write strategies was published by the Ibbotson Associates consulting firm. After mid-2004, there are many new covered call investment products that were introduced.
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