Covered call

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Payoffs and profits from buying stock and writing a call. Covered Call.jpg
Payoffs and profits from buying stock and writing a call.

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time the trader sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

Call option company

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.

The term buy-write is used to describe an investment strategy in which the investor buys stocks and writes call options against the stock position. The writing of the call option provides extra income for an investor who is willing to forgo some upside potential.

Contents

The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if the buyer decides to exercise.

The owner of an option contract has the right to exercise it, and thus require that the financial transaction specified by the contract is to be carried out immediately between the two parties, whereupon the option contract is terminated. When exercising a call option, the owner of the option purchases the underlying shares at the strike price from the option seller, while for a put option, the owner of the option sells the underlying to the option seller, again at the strike price.

Writing (i.e. selling) a call generates income in the form of the premium paid by the option buyer. And if the stock price remains stable or increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money. [1]

Since in equilibrium the payoffs on the covered call position is the same as a short put position, the price (or premium) should be the same as the premium of the short put or naked put.

In finance, a put or put option is a stock market device which gives the owner the right, but not the obligation, to sell an asset, at a specified price, by a predetermined date to a given party. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

Naked put

A naked put is a put option contract where the option writer does not hold the underlying position, in this case a short equity position, to cover the contract in case of assignment. The seller receives the premium cost of the put price, and hopes that the underlying equity or stock price stays the same or rises modestly, in which case the seller retains the premium. A put option buyer is hoping for a decrease in the price of the underlying equity, and upon exercise or expiration will collect cash representing the difference between the strike price of the option and the price of the underlying equity.

Examples

Trader A ("A") has 500 shares of XYZ stock, valued at $10,000. A sells (writes) 5 call option contracts, bought by Investor B ("B") (in the US, 1 option contract covers 100 shares) for $1500. This premium of $1500 covers a certain amount of decrease in the price of XYZ stock (i.e. only after the stock value has declined by more than $1500 would the owner of the stock, A, lose money overall). Losses cannot be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer ("B") to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and A, the seller (writer), will keep the money paid on the premium of the option. Thus, A's loss is reduced from a maximum of $10000 to [$10000 - (premium)], or $8500.

This "protection" has its potential disadvantage if the price of the stock increases. If B exercises the option to buy, and the stock price has increased such that A's shares of XYZ are now worth more than $10,000 in the market, A (the option writer) will be forced to sell the stock below market price at expiration, or must buy back the calls at a price higher than A sold them for.

If, before expiration, the spot price does not reach the strike price, the investor might repeat the same process again if he believes that stock will either fall or be neutral.

A call option can be sold even if the option writer ("A") does not initially own the underlying stock, but is buying the stock at the same time. This is called a "buy write". If XYZ trades at $33 and $35 calls are priced at $1, then A can purchase 100 shares of XYZ for $3300 and write/sell one (100-share) call option for $100, for a net cost of only $3200. The $100 premium received for the call will cover a $1 decline in stock price. The break-even point of the transaction is $32/share. Upside potential is limited to $300, but this amounts to a return of almost 10%. (If the stock price rises to $35 or more, the call option holder will exercise the option and A's profit will be $35–32 = $3) If the stock price at expiry is below $35 but above $32, the call option will be allowed to expire, but A (the seller/writer) can still profit by selling the shares. Only if the price is below $32/share will A experience a loss.

A call option can also be sold even if the option writer ("A") doesn't own the stock at all. This is called a "naked call". It is more dangerous, as the option writer can later be forced to buy the stock at the then-current market price, then sell it immediately to the option owner at the low strike price (if the naked option is ever exercised).

Payoffs from a short put position, equivalent to that of a covered call Short put option.svg
Payoffs from a short put position, equivalent to that of a covered call

To summarize:

Stock price
at expiration
Net profit/lossComparison to
simple stock purchase
$30(200)(300)
$31(100)(200)
$320(100)
$331000
$34200100
$35300200
$36300300
$37300400

Marketing

This strategy is sometimes marketed as being "safe" or "conservative" and even "hedging risk" as it provides premium income, but its flaws have been well known at least since 1975 when Fischer Black published "Fact and Fantasy in the Use of Options". According to Reilly and Brown,: [2] "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."

Two recent developments may have increased interest in covered call strategies: (1) in 2002 the Chicago Board Options Exchange introduced a benchmark index for covered call strategies, the CBOE S&P 500 BuyWrite Index (ticker BXM), and (2) in 2004 the Ibbotson Associates consulting firm published a case study on buy-write strategies. [3]

This type of option is best used when the investor would like to generate income off a long position while the market is moving sideways. It allows an investor/writer to continue a buy-and-hold strategy to make money off a stock which is currently inactive in gains. The investor/writer must correctly guess that the stock won't make any gains within the time frame of the option; this is best done by writing an out-of-the-money option. A covered call has lower risk compared to other types of options, thus the potential reward is also lower.

See also

Related Research Articles

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In finance, a short sale is the sale of an asset that the seller has borrowed in order to profit from a subsequent fall in the price of the asset. After borrowing the asset, the short seller sells it to a buyer at the market price at that time. Subsequently, the resulting short position is "covered" when the seller repurchases the same asset in a market transaction and delivers the purchased asset back to the lender to replace the asset that was initially borrowed. In the event of an interim price decline, the short seller will profit, since the cost of (re)purchase will be less than the proceeds received upon the initial (short) sale. Conversely, the short position will result in a loss if the price of a shorted asset rises prior to repurchase.

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The CBOE S&P 500 BuyWrite Index is a benchmark index designed to show the hypothetical performance of a portfolio that engages in a buy-write strategy using S&P 500 index call options.

In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range. A collar strategy is used as one of the ways to hedge against possible losses and it represents long put options financed with short call options.

Iron butterfly (options strategy) name of an advanced, neutral-outlook, options trading strategy

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The CBOE S&P DJIA BuyWrite Index is a benchmark index designed to show the hypothetical performance of a portfolio that engages in a buy-write strategy on the Dow Jones Industrial Average (DJIA).

Credit spread (options)

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References

  1. Warner, Adam (2009). "Chapter 12: Buy-Write--You Bet". Options Volatility Trading: Strategies for Profiting from Market Swings (1 ed.). Amazon.com: McGraw-Hill. pp. 188, 177–193. ISBN   978-0-07-162965-2. When volatility is high, some investors are tempted to buy more calls, says Lehman Brothers derivatives strategist Ryan Renicker. But volatility is also highest when the market is pricing in its worst fears...overwriting strategies that are dynamically rebalanced ahead of large market rallies or downturns can naturally enhance the returns generated, say Renicker and Lehman's Devapriya Mallick.
  2. Reilly and Brown. "Investment Analysis and Portfolio Management." South-Western College Pub. p. 995
  3. Buy Writing Makes Comeback as Way to Hedge Risk, Pensions & Investments, (May 16, 2005)

Bibliography