Call Writing Explained

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The Basics of Covered Calls

Professional market players write covered calls to increase investment income, but individual investors can also benefit from this conservative but effective option strategy by taking the time to learn how it works and when to use it. In this regard, let’s look at the covered call and examine ways it can lower portfolio risk and improve investment returns.

What Is a Covered Call?

You are entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash, meaning the buyer of the option gets the right to own your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock or one futures contract at the strike price any time on or before expiration. If the seller of the call option also owns the underlying security, the option is considered “covered” because he or she can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call

Profiting from Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price. The premium is a cash fee paid on the day the option is sold and is the seller’s money to keep, regardless of whether the option is exercised or not.

When to Sell a Covered Call

When you sell a covered call, you get paid in exchange for giving up a portion of future upside. For example, let’s assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You’re also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. In this scenario, selling a covered call on the position might be an attractive strategy.

The stock’s option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against your shares, which you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.

On the other hand, you’ll incur a $10 loss on the original position if the stock falls to $40. However, you get to keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.

Bullish Scenario: Shares rise to $60 and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $60 – option is exercised because it is above $55 and you receive $55 for your shares.
July 1 PROFIT: $5 capital gain + $4 premium collected from sale of the option = $9 per share or 18%
Bearish Scenario: Shares drop to $40 and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 – expires on June 30, exercisable at $55
June 30 Stock closes at $40 – option is not exercised and it expires worthless because stock is below strike price. (the option buyer has no incentive to pay $55/share when he or she can purchase the stock at $40)
July 1 LOSS: $10 share loss – $4 premium collected from sale of the option = $6 or -12%.

Advantages of Covered Calls

Selling covered call options can help offset downside risk or add to upside return, taking the cash premium in exchange for future upside beyond the strike price plus premium.during the contract period. In other words, if XYZ stock in the example closes above $59, the seller makes less money than if he or she simply held the stock. However, if the stock ends the six-month period below $59 per share, the seller makes more money or loses less money than if the options sale hadn’t taken place.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they’ll be holding naked calls, which have theoretically unlimited loss potential if the underlying security rises. Therefore, sellers need to buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

The Bottom Line

Use covered calls to decrease the cost basis or to gain income from shares or futures contracts, adding a profit generator to stock or contract ownership.

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Writing An Option

What is Writing an Option?

Writing an option refers to an investment contract in which a fee, or premium, is paid to the writer in exchange for the right to buy or sell shares at a future price and date. Put and call options for stocks are typically written in lots, with each lot representing 100 shares.

Key Takeaways

  • Traders who write an option receive a fee, or premium, in exchange for giving the option buyer the right to buy or sell shares at specific price and date.
  • Put and call options for stocks are typically written in lots, with each lot representing 100 shares.
  • The fee, or premium, received when writing an option depends upon several factors, such as the current price of the stock and when the option expires.
  • Benefits of writing an option include receiving an immediate premium, keeping the premium if the option expires worthless, time decay and flexibility.
  • Writing an option can involve losing more than the premium received.

Basics of Writing an Option

Traders write an option by creating a new option contract that sells someone the right to buy or sell a stock at a specific price (strike price) on a specific date (expiration date). In other words, the writer of the option can be forced to buy or sell a stock at the strike price. However, for that risk, the option writer receives a premium that the buyer of the option pays. The premium received when writing an option depends upon several factors, including the current price of the stock, when the option expires and other factors such as the underlying asset’s volatility.

Benefits of Writing an Option

Some of the main benefits of writing an option include:

Premium Received Immediately: Options writers receive a premium as soon as they sell an option contract.

Keep Full Premium for Expired Out of the Money Options: If the written option expires out of the money—meaning that the stock price closes below the strike price for a call option, or above the strike price for a put option—the writer keeps the entire premium.

Time Decay: Options decline in value due to time decay, which reduces the option writer’s risk and liability. Because the writer sold the option for a higher price and has already received a premium, they can buy it back for a lower price.

Flexibility: An options writer has the flexibility to close out their open contracts at any time. The writer removes their obligation by simply buying back their written option in the open market.

Risk of Writing an Option

Even though an option writer receives a fee, or premium for selling their option contract, there’s the potential to incur a loss. For example, let’s say David thinks Apple Inc. (AAPL) shares will stay flat until the end of the year due to a lackluster launch of the tech company’s iPhone 11, so he decides to write a call option with a strike price at $200 that expires on Dec. 20.

Unexpectedly, Apple announces that it plans on delivering a 5G capability iPhone sooner than expected, and its stock price closes at $275 on the day the option expires. David still has to deliver the stock to the option buyer for $200. That means he will lose $75 per share as he has to buy the stock on the open market for $275 to deliver to his options buyer for $200.

Practical Example of Writing an Option

Let’s assume The Boeing Company (BA) is trading at $375 and Sarah owns 100 shares. She believes the stock will trade flat to slightly lower over the next two months as investors wait for news about when the company’s troubled 737 MAX jet will gain permission to fly again. Tom, on the other hand, believes the Federal Aviation Administration (FAA) will allow the airplane to fly within weeks rather than months and anticipates a sharp rise in Boeing’s share price.

Therefore, Sarah decides to write a $375 November call option (equal to 100 shares) at $17. At the same time, Tom places an order to buy a $375 November call at $17. Consequently, Sarah and Tom’s orders transact which deposits a $1,700 premium into Sarah’s bank account and gives Tom the right to buy her 100 shares of Boeing at $375 at any time before the November expiry date.

Suppose no news gets released about when the 737 MAX can fly again before the option expires, and as a result, Boeing’s share price remains at $375. As a result, the option expires worthless, meaning Sarah keeps the $1,700 premium paid by Tom.

Alternatively, assume the FAA grants permission for the 737 MAX to fly before the Nov. 15 expiry date and Boeing’s stock jumps to $450. In this case, Tom exercises his option to buy 100 shares of Boeing from Sarah at $375. Although Sarah received a $1,700 premium for writing the call option, she also lost $7,500 because she had to sell her stock that is worth $450 for $375.

Writing Covered Calls

Writing a covered call means you’re selling someone else the right to purchase a stock that you already own, at a specific price, within a specified time frame. Because one option contract usually represents 100 shares, to run this strategy, you must own at least 100 shares for every call contract you plan to sell.

As a result of selling (“writing”) the call, you’ll pocket the premium right off the bat. The fact that you already own the stock means you’re covered if the stock price rises past the strike price and the call options are assigned. You’ll simply deliver stock you already own, reaping the additional benefit of the uptick on the stock.

Here’s how you can write your first covered call

First, choose a stock in your portfolio that has already performed well, and which you are willing to sell if the call option is assigned. Avoid choosing a stock that you’re very bullish on in the long-term. That way you won’t feel too heartbroken if you do have to part with the stock and wind up missing out on further gains.

Now pick a strike price at which you’d be comfortable selling the stock. Normally, the strike price you choose should be out-of-the-money. That’s because the goal is for the stock to rise further in price before you’ll have to part with it.

Next, pick an expiration date for the option contract. Consider 30-45 days in the future as a starting point, but use your judgment. You want to look for a date that provides an acceptable premium for selling the call option at your chosen strike price.

As a general rule of thumb, some investors think about 2% of the stock value is an acceptable premium to look for. Remember, with options, time is money. The further you go out in time, the more an option will be worth. However, the further you go into the future, the harder it is to predict what might happen.

On the other hand, beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock, and remember if something seems too good to be true, it usually is.

There are three possible outcomes for this play:

Scenario 1: The stock goes down

If the stock price is down at the time the option expires, the good news is the call will expire worthless, and you’ll keep the entire premium received for selling it. Obviously, the bad news is that the value of the stock is down. That’s the nature of a covered call. The risk comes from owning the stock. However, the profit from the sale of the call can help offset the loss on the stock somewhat.

If the stock takes a dive prior to the expiration date of the call, don’t panic. You’re not locked into your position. Although losses will be accruing on the stock, the call option you sold will go down in value as well. That’s a good thing because it will be possible to buy the call back for less money than you received to sell it. If your opinion on the stock has changed, you can simply close your position by buying back the call contract, and then dump the stock.

Scenario 2: The stock stays the same or goes up a little, but doesn’t reach the strike price

There’s really no bad news in this scenario. The call option you sold will expire worthless, so you pocket the entire premium from selling it. Perhaps you’ve seen some gains on the underlying stock, which you will still own. You can’t complain about that.

Scenario 3: The stock rises above the strike price

If the stock is above the strike price at expiration, the call option will be assigned and you’ll have to sell 100 shares of the stock.

If the stock skyrockets after you sell the shares, you might consider kicking yourself for missing out on any additional gains, but don’t. You made a conscious decision that you were willing to part with the stock at the strike price, and you achieved the maximum profit potential from the strategy.

Pat yourself on the back. Or if you’re not very flexible, have somebody else pat your back for you. You’ve done well.

The recap on the logic

Many investors use a covered call as a first foray into option trading. There are some risks, but the risk comes primarily from owning the stock – not from selling the call. The sale of the option only limits opportunity on the upside.

When running a covered call, you’re taking advantage of time decay on the options you sold. Every day the stock doesn’t move, the call you sold will decline in value, which benefits you as the seller. (Time decay is an important concept. So as a beginner, it’s good for you to see it in action.)

As long as the stock price doesn’t reach the strike price, your stock won’t get called away. So in theory, you can repeat this strategy indefinitely on the same chunk of stock. And with every covered call you run, you’ll become more familiar with the workings of the option market.

You may also appear smarter to yourself when you look in the mirror. But we’re not making any promises about that.

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