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Writing A Covered Call

Writing a covered call consists of the sale of a call while

simultaneously owning the underlying security.The seller of the call (the writer) is usually negative or neutral on the direction of

the underlying security.Although, it can also be viewed as a mildly bullish position.

Should the underlying security rise in price, he will not participate fully in the rise.However, he has now protected himself should the security decline in price.

f the underlying security remains relatively unchanged, he will profit if the call e!piresworthless.

An investor would want to write calls against the stoc" that he owns to increase income anddecrease the volatility of his portfolio.

#wning the stoc" outright has the disadvantage of leaving the owner vulnera$le to sideways

moves and declines in price.n fact, the only time the call writer doesn%t do well writing a covered call is if the underlyingsecurity rises in price $y a su$stantial amount.

The call writer&s position will outperform the other position if the underlying security rises inprice slightly, stays the same, or declines in price.

'ecause of the advantages of writing calls, many portfolio managers, institutions, and privateinvestors, are writing more and more calls.

or an e!ample of the covered call write, assume an investor owns ** shares of +- which iscurrently trading at /0.**.

urther assume that the +- 1ovem$er /2.** call is presently trading at 0.32.

The stoc" owner might sell one +- 1ovem$er /2.** call for 0.32.His present position would $e long ** shares of +- at /0.**,short +- 1ovem$er /2.** call.

'ecause one call option can $e e!ercised for ** shares of stoc", the seller (writer) of the calloption has covered his short position.

Should the call go in4the4money, and the holder e!ercise the call, the writer can cover thee!ercise $y surrendering the stoc".

The call writer receives 032.** from the sale of the call.Should +- close $elow /2.** at 1ovem$er e!piration, the option e!pires worthless, and the

covered call writer will profit in the amount of 032.**.He has also $ought himself 0.32 of downside protection.

+- can decline in price from /0.** to 5/.02 $efore the holder of the stoc" e!periences aloss.

The greatest amount of loss is incurred if the price of +- declines $elow 5/.02.'elow 5/.02, the investor incurs losses which e!ceed the protection from the sale of the call.

'rea" even point 6 stoc" price at the time of the call sale 4 the price of the call.

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#ne can also see that if +- rises in price up to /2.** at 1ovem$er e!piration, the covered callwriter will profit $y $oth, the increase in price of the underlying security and the call e!piring

worthless.This is where the ma!imum profit can $e earned.

At e!piration, if +- closes a$ove /2.**, the call will $e e!ercised.

At this point, the covered call writer has two choices.He can do nothing and his stoc" will $e sold at the price of /2.**.n which case, the writer will have a 032.** profit on the sale of the call and a 7.** profit

$ecause of the rise in +- stoc".However, he wouldn%t own the stoc" anymore.

Alternatively, if he wants to continue to own the stoc", he could cover ($uy $ac") the call in theopen mar"et.

f he chooses the second alternative, he may have a loss on the call option8 however, he will havean even larger profit from the increase in the ownership of the stoc" (underlying security).

9epending on which call option the investor chooses to write, the position can $e considered

aggressive or conservative.Writing an out4of4the money call is an aggressive position.And writing an in4the4money call is a conservative position.

As an e!ample of a conservative covered call write, assume +- is trading at /:.**.urther assume that the +- 1ovem$er /*.** call option is trading at ;.02.

And the 1ovem$er **.** call option is trading at .02.The investor decides to write

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=eople with large holdings of a particular stoc" might also consider writing covered calls againstseveral different dates.

1ear term, medium term, and long term covered calls can $e written.

Additionally, different stri"es can $e written.

n4the4money and out4of4the money calls can $e written.

f the underlying security declines su$stantially in price, the follow up action is to roll intoanother position.

This involves $uying $ac" the written call option and selling another call option.Consider the following>

A covered call write was esta$lished when +- was at /:.** and the 1ovem$er /*.** calloption was sold for ;.02.

A month later, +- drops in price to 55.**.

The 1ovem$er /*.** call option is now worth .02.At this time, the investor has a loss of ;.** on the underlying security and a gain of 2.** on the1ovem$er /*.** call.

His overall position is now at a loss of .**.The present call only has .02 more of downside protection.

What the investor might do now is $uy $ac" the 1ovem$er /*.** call option at .02 and sellthe ?anuary 52.** for what might $e selling for 2.**.

He would now have another 7.** in downside protection while leaving his $rea" even point in a$etter position.

Additionally, if +- sta$ili@es at 55.**, the covered call writer would earn another few dollarsin profit, which he wouldn%t have earned if he didn%t roll down.

#ccasionally, rolling down will loc" in a loss.However, loc"ing in this loss will usually outperform not rolling down or not writing a covered

call in the first place.

1ow, what happens if the covered call writer finds himself in the position where the stoc" hasrisen in price

The call writer can close the position or roll up into another position.f the writer rolls up to another position, and closes his original position $y $uying $ac" the call

option, he has increased his profit potential.However, he has decreased his downside protection $y the difference $etween the two stri"e

prices.

When the option is at parity is when the option is most li"ely to $e e!ercised.

The last point want to ma"e is that if you are writing a covered call for downside protection,you shouldn%t worry if the stoc" gets called away.

ou can always $uy the stoc" $ac" if you really want to hold it in your portfolio.

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#ne of the $iggest traps investors fall into with this options strategy is that they $ecome marriedto that particular stoc" and don%t want to lose it.

Stoc" isn%t even a thing.t represents ownership in a corporation.

To $ecome emotionally attached to it is ridiculous.