Forest Hill Financial Advisory Group

A Closer Look at the Covered Call Strategy


What is a covered call strategy?

A covered call contract is a financial market transaction in which the seller of a call option contract owns 100 shares of the corresponding stock and agrees to sell those underlying shares of stock at a specified strike price in turn for receiving an immediate premium for entering into the contract. If multiple hundred shares of the stock are owned, it is possible to sell multiple call contracts with each contract representing 100 shares of that stock. The long position in the underlying stock is said to provide the "cover" as the shares can be delivered to the buyer of the call if the call is assigned sometime during the option contract period, typically several months into the future.

Writing a call generates income in the form of the premium paid by the option buyer. If the stock price remains stable or increases but does not exceed the call contract’s strike price, then the owner of the underlying stock and seller of the call option makes a short term gain on this income. He/she still owns the underlying stock and any dividends paid. If the stock takes off and exceeds the strike price during the contract period, the gains above the call strike price would go to the buyer of the call contract unless the writer executes a defensive spread maneuver. In this spread contract, he buys the old contract back and sells a new call contract at a higher price and further out in the future.

In such a case, the underlying stock’s gains can be increased but not enough to compensate for all of the initial loss of some of the upward market gains. The risk of stock ownership is not eliminated with the use of options – it is just mitigated depending on the strategy used. If the stock price declines, then the net position will likely lose money even though a positive short term gain resulted from the initial call writing. Stock selection is still an important element in achieving better than market returns on client investments.

 

Benefits of Covered Call Strategies

This strategy generates income because the investor keeps the premium received from writing (selling) the call and can also offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price. It is a lower risk, hedging strategy that is uniquely different from the other 26 option strategies that have been used by options professionals since the 1980’s.

At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call contract and is obligated to sell his shares at the agreed upon  strike price. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

How it Works

Let's say that you own shares of the ABC Manufacturing and like its long-term growth prospects as well as its dividend yield but feel, in the shorter term, the stock will likely trade relatively flat, perhaps within a few dollars of its current price of $25. If you sell a call option on ABC Manufacturing at a strike price of $28, you earn the premium from the option sale but cap your upside gains at $28. One of four scenarios is going to play out:

a) ABC Manufacturing shares trade flat over the contract period (below the $28 strike price) - the option will expire worthless and you keep the premium from selling the option. In this case, by using the buy-write strategy you have successfully outperformed the stock by virtue of the added call premium return on your stock investment. It is similar to adding a dividend stream to a stock that may or may not actually pay a regular dividend. The difference is that call premiums are taxed as short term capital gains not as dividends.

b) ABC Manufacturing shares fall - the option expires worthless, you keep the premium, and again you outperform the stock which lost value for those who had no call premium income.

c) ABC manufacturing shares rise above $28 during the contract period - the option is exercised, and your upside is capped at the $28 strike price that you receive, plus the original option premium. In this case, if the stock price goes higher than $28, plus the premium, your buy-write strategy has underperformed the hold strategy for ABC shares without a call strategy.

d) ABC manufacturing shares rise above $28; however, you decide to hold on to the stock for long term appreciation and you execute a “spread” option. The spread option is a two-step call transaction in which you buy back the original call contract at the market option price and then sell a new call option at a higher price (perhaps above the current ABC price) so that the call is not assigned and you continue to own the stock and all future dividend rights. In this case, you are putting some money back into the continuing ownership of the stock while holding onto it for long term gains currently taxed at the lower 15% rate.

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