Payoffs and profits from buying stock and writing a call.
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.
The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if he decides to exercise.
Writing a call generates income, in the form of the premium paid by the option buyer, and if the stock price remains stable or increases the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines the net position will likely lose money.
Since in equilibrium the payoffs on the covered call position is the same as a short put position, the price (or premium) should be the same as the premium of the short put or naked put.
Examples
An investor has 500 shares of XYZ stock, valued at $10,000. He sells 5 call option contracts (in the US, 1 option contract covers 100 shares) for $1500 , thus covering a certain amount of decrease in the XYZ stock (i.e. only after the stock value has declined by more than $1500 would the investor lose money overall). Losses can not be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and the seller (writer) will keep the money paid on the premium of the option, thus reducing his loss from a maximum of $10000 to $10000 - (premium), or $8500.
This "protection" has its potential disadvantage in that the investor (option writer) may be forced to sell his stock below market price at expiry, or must buy back the calls at a price higher than he sold them for.
If before expiration the spot price does not reach the strike price, the investor might repeat the same process again if he/she believes that stock will either fall or be neutral.
A call option can be sold even if the option writer doesn't initially own the underlying stock. If XYZ trades at $33 and $35 calls are priced at $1, then an investor can purchase 100 shares of XYZ for $3300 and sell one (100-share) call option for $100, for a net cost of only $3200. The $100 premium received for the call will cover a $1 decline in stock price. The break-even point of the transaction is $32/share. Upside potential is limited to $300, but this amounts to a return of almost 10%. (If the stock price rises to $35 or more, the call option holder will exercise his option and the investor's profit will be $35–$32 = $3). If the stock price at expiry is below $35 but above $32, the call option will be allowed to expire, but the investor can still profit by selling his shares. Only if the price is below $32/share will the investor experience a loss.
Payoffs from a short put position, equivalent to that of a covered call
To summarize:
Stock price
at expiration |
Net profit/loss |
Comparison to
simple stock purchase |
| $30 |
(200) |
(300) |
| $31 |
(100) |
(200) |
| $32 |
0 |
(100) |
| $33 |
100 |
0 |
| $34 |
200 |
100 |
| $35 |
300 |
200 |
| $36 |
300 |
300 |
| $37 |
300 |
400 |
Marketing
This marketing strategy is sometimes categorized as "safe" or "conservative" and even "hedging risk" as it provides high income and its flaws are well known since 1975 when Fischer Black published his theory in "Fact and Fantasy in the Use of Options. According to Reilly and Brown (2003); "to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels." (p. 995)
In recent years, the interest in covered call strategies has been enhanced by two developments according to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005): (1) in 2002 the Chicago Board Options Exchange introduced the first major benchmark index for covered call strategies, the CBOE S&P 500 BuyWrite Index (ticker BXM), and (2) in 2004 the Ibbotson Associatesconsulting firm published a case study on buy-write strategies. After mid-2004, many new covered call investment products were introduced.
References
- Chicago Board Options Exchange [1]
- Screen market for covered calls [2]
- Covered Call Rank [3]
External links
Bibliography
- Brill, Maria. "Options for Generating Income." Financial Advisor. (July 2006) pp. 85-86.
- Calio, Vince. Covered Calls Become Another Alpha Source." Pensions & Investments. (May 1, 2006).
- Callan Associates. "An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy."(October 2006).
- Corbin, David; Villegas, Melissa. "For Less Market Risk, Consider Covered Calls." Fort Worth Business Press, July 30, 2004.
- "Covered Call Strategy Could Have Helped, Study Shows" Pensions & Investments, Sept. 20, 2004, p. 38.
- Crawford, Gregory. "Buy Writing Makes Comeback as Way to Hedge Risk." Pensions & Investments. May 16, 2005.
- Demby, Elayne Robertson. "Maintaining Speed -- In a Sideways or Falling Market, Writing Covered Call Options Is One Way To Give Your Clients Some Traction." Bloomberg Wealth Manager, February 2005.
- Feldman, Barry, and Dhruv Roy, "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index." The Journal of Investing. (Summer 2005).
- Ferry, John. "An Array of Options - A Buy-write Strategy Can Add Some Octane to Portfolios When the Markets Lack Direction." Worth Magazine, April 2005, pp. 102 - 104.
- Frankel, Doris. "Buy-writes Catch on in Sideways U.S. Stock Market." Reuters. (Jun 17, 2005).
- Fulton, Benjamin T., and Matthew T. Moran. "BuyWrite Benchmark Indexes and the First Options-Based ETFs" Institutional Investor—A Guide to ETFs and Indexing Innovations (Fall 2008), pp. 101–110.
- Hill, Joanne, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens. "Finding Alpha via Covered Index Writing." Financial Analysts Journal. (Sept.-Oct. 2006). pp. 29-46.
- Lauricella, Tom. "'Buy Write' Funds May Well Be The Right Strategy." Wall Street Journal. (Sep 8, 2008). pg. R1.
- Moran, Matthew. "Risk-adjusted Performance for Derivatives-based Indexes - Tools to Help Stabilize Returns." The Journal of Indexes. (Fourth Quarter, 2002) pp. 34 - 40.
- Roeder, David. "New Funds Try Options to Boost Stock Income." Chicago Sun-Times. Sunday, October 10, 2004, Page 43A.
- Schneeweis, Thomas, and Richard Spurgin. "The Benefits of Index Option-Based Strategies for Institutional Portfolios" The Journal of Alternative Investments, Spring 2001, pp. 44 - 52.
- Sears, Steven M. "'Buy-Writes' Soar in Favor." Barron's. (Dec 8, 2008) pg. M9.
- Smith, Steven "More Options on Covered Calls" TheStreet.com., Oct. 13, 2004
- Tan, Kopin. "Covered Calls Grow in Popularity as Stock Indexes Remain Sluggish." Wall Street Journal, April 12, 2002.
- Tergesen, Anne. "Taking Cover with Covered Calls." Business Week, May 21, 2001, p. 132.
- Tracy, Tennille. "'Buy-Write' Is Looking Attractive." Wall Street Journal. (Dec 1, 2008). pg. C6.
- Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index." The Journal of Derivatives (Winter 2002) pp. 35 - 42.
