Covered Call Option Strategy

An option is the right to buy or sell something at some future date, at a set price.

You could sell me an option to buy your house for $300,000 at any time between now and July 1, 2016. If your house is currently worth $100,000, I won’t pay you much for that option, because the chances of it increasing by 300% during that time frame is very small. However, if your house is currently worth $400,000 and is likely to increase in value, I am willing to pay you at least $100,000 for the option to purchase your $400,000 house for $300,000 at some future date.

How much will I pay for an option? I will pay what it’s worth ($100,000 in the example above), plus a time premium.

While house options are uncommon, stock options are very common, and there are two types: calls and puts.

A call option gives you the right to buy a stock at a set price, up to a certain date. In other words you have the option to call the stock away from the owner of the stock.

A put option gives you the write to sell a stock at a set price, up to a certain date. In other words you have the option to put the stock back to the person who will become the owner of the stock.

An example:

Stock ABC is currently selling for $30, and I buy a call option on the stock, giving me the right to buy the stock for $30 on a date one month from today. What would I pay for that option? Intrinsically the option is worthless, since I can buy the stock for $30 on the open market today. The price I pay will only be the time premium on the stock, or the premium I am willing to pay to obtain the right to only pay $30 for the stock.

If I expect the stock to be worth $32 one month from today, I might be willing to pay $1 for the option. I would then exercise my option in one month and pay $30 to buy the stock, and I could then immediately sell the stock for its market value of $32. My profit would be $1 ($32 less the $30 I paid for the stock, less the $1 I paid for the option).
With that background, let’s discuss covered call option writing. Here’s an example:

I own 100 shares of ABC Company Inc. worth $30. Long term I know the shares will increase in value, so I don’t want to sell them. However, I’m worried that over the short term the shares may drop slightly in value. To help mitigate that potential loss, I can “cover” my shares by selling call options on shares I already own.

Stock option contracts are for 100 share blocks, so I can sell 1 call option contract, representing 100 shares. I decide to sell the $30 call option that expires in one month. The current quote is for $1, so I sell the contract for the $30 call option, expiring in one month, for $1. I realize $100 dollars for my 100 share contract (less commissions).

If one month from today when the option matures ABC Company Inc. is trading for $30 or less, the options expire worthless. Let’s assume that ABC is trading for $29.50 on the options maturity date.

The person who owns the call will not exercise it, since it makes no sense to pay me $30 for a stock they can buy on the open market for $29.50; the options expire worthless. I sold them for $1, so I get to keep the $1.

In this example I lost 50 cents by holding the stock (it dropped from $30 to $29.50), but I made $1 selling the options, so even though the stock dropped by 50 cents, I actually made a 50 cent profit (ignoring commissions).  That, in simple terms, is the point of a covered call writing strategy.

Unlike buying naked calls, covered call writing is a conservative strategy.

You could go out and buy a call for $1.  If the underlying stock doesn’t increase, you lose everything.  Of course if the stock goes way up you could make a huge profit in a short time.  It’s boom or bust.

Writing a covered call limits your upside, because if the stock goes way up my stock is called away, so all I earn is the premium.  If the stock drops, my loss is mitigated by the premium.  I make less on the way up, but lose less on the way down.  That’s the mitigating impact of a covered call writing strategy.