Understanding Covered Calls - Part 1

The covered call is not only one of the most common, but it is also one of the most easily understood methods used by options investors. This article provides a brief overview of covered as well as information about how to get started in covered call investing.

A covered call is a very simple device to understand. It is a type of option where the investor writes call contracts to sell an equity or commodity at a certain price, on or before a specified end-date. For each call contract written, the investor must hold 100 shares of the underlying security. The investor is paid a premium when the call contracts are sold. This premium is paid to the investor by the buyer of the options contract, which results in money deposited into the investor’s account. Simply put, a covered call is termed “covered” because the investor owns 100 shares of the underlying for every 1 call option sold. A covered call uses the term “call” because the investor is selling call options.

Example – Writing Covered Calls

An investor holds 1000 shares of QQQQ on August 16 th, 2006 valued at $37.70 per share

The investor writes 10 call options at $39.00 per share strike price for his QQQQ holdings with an expiration date of Friday September 15, 2006 @ $.30 per share

When the call options sell, the investor receives $300 in his account. These are the proceeds for the call option contracts, and are the investor’s to keep

A covered call is often described as a “conservative” options strategy. The word conservative is a bit of a misnomer here. Covered calls are conservative in relation to other types of options trading which entail more risk. When you see the term “conservative” associated with covered calls in publications or on the Internet, do not assume that covered calls are risk free. They are not risk free. Covered calls entail a significant amount of risk and should only be used after the investor develops a keen understanding of options and options trading.

What Happens after a Contract is Sold?

The option expires worthless on the expiration dateThe option is exercised and the underlying security is “called away”The investor chooses to close his position by buying back his options.According to the CBOE, about 30% of all call options expire on their expiration date, as worthless as the paper that they aren’t written on! A more detailed examination of why this happens is out of scope for this article, but suffice to say that the people that purchased the call initially a betting a small amount (the premium) that the underlying security will rise to the strike price agreed to in the options contract.

However, should the price of QQQQ in the above example equal or exceed $39.00 on September 15, 2006, in all probability the 1000 shares of QQQQ will be “called away”, which means that the person who purchased the contract has exercised their option to buy the shares of QQQQ at the agreed upon price. Thus, when an investor writes a covered call contract, he is obligated to sell those shares to the person who purchased the contract at any time from the sale date until the option expiration. According to the CBOE, 10% of all options fall into this category.

the bulk of all options, 60%, are traded out. “Traded out” means that the investor purchased his call options back and effectively closed his position.

Advantages and Disadvantages

One major advantage of writing covered calls is that the investor immediately receives the premium amount in his account. The second advantage is that the investor has effectively increased the earnings potential of their long-term investment by generating additional income from covered call premiums. In the example above, the investor generated an additional .79% income per month. This doesn’t sound like much, but on an annualized basis this equals a whopping 9.68% income from a stock that is being held long.

Thus, if the investor where simply holding a stock long-term, he typically looks forward to a 6% to 7% gain in value over a year’s time. By implementing a simple covered call strategy, the investor has increased his potential income by 9.68% by taking simple actions. This is significant: Over a 30 year period (without inflation) the investor simply holding 1000 shares of QQQQ can expect his investment value to increase from $37,700 to $76,882, assuming a 6.5% annualized return. On the other hand, the investing holding 1000 shares of QQQQ long-term and implementing a simple covered call strategy can expect his investment value to increase from $37,700 to $1,089,464! The example presented is very simple and very conservative; a skilled and careful investor can earn much more selling covered calls.

Some disadvantages include that the investor is not allowed to sell the shares of QQQQ while any call contracts are outstanding for those underlying shares. This could be a problem if there is a significant market downturn and the investor decides to sell. In this case, many investors will promptly buy back their call options so that they are free to do as they wish with the underlying stock.

That’s a very basic look at what a covered calls are and how writing covered calls work. This is by no means meant to provide a comprehensive overview of the entire process of options trading or even everything there is to know about covered calls. However, this article provides a good starting point for learning more information about covered calls. As the example above demonstrated, the difference over 30 years between writing covered calls and not writing covered calls is significant enough to warrant an understanding of this simple method of profiting from the options market.

Nothing published by CoveredCallMall should be considered personalized investment advice. Although our articles may answer your general questions or otherwise provide inspirations, this information should not be deemed personalized investment advice. Any information offered by CoveredCallMall should only be acted upon after consulting with a financial advisor and only after reviewing the prospectus and/or financial statements of the specific investment. CoveredCallMall, its employees, editors, agents, and owners are not responsible for errors, omissions, or loss.

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Author – Michael Scarborough for CoveredCallMall.com, August 15, 2006

Michael Scarborough is a full time options trader and staff writer for CoveredCallMall.com