Covered Call Options
New to covered call options? That’s okay – here are the basics.
Let’s start with some basic questions and answers.
Q. What is a covered call option?
A. A covered call option gives the holder of the option, or buyer the right but not the obligation to purchase shares from the writer, or seller of that option at a specific price within a specific period of time, typically one to two months.
Q. What is writing covered calls?
A. Writing a covered call is offering shares you own at an agreed price on or before an agreed date, often one or two months in the future.
Here’s an example. Say you own 100 shares of DIA (Diamonds Trust; DIA is an ETF that seeks to mirror the performance of the Dow Jones Industrial Average.) You purchased those shares at $100 per share, for a total cost of $10,000. You can write a covered call, promising to sell those shares at the strike price of $105. The expiration date for that covered call is approximately one month away. The buyer of your covered call pays you a premium for the right to buy your DIA shares at $105; in this case he pays $1.87 per share, or $187 total. You receive those funds immediately. If the strike price of $105 is reached at any time during the month (up to the expiration date), the buyer may exercise his option. If he does, you must sell your 100 shares for $105 per share, for a total of $$10,500. If the buyer does not exercise the option, you keep the premium and the shares. (In fact, you keep the premium no matter what the outcome.) You can then write more covered calls and generate additional income.
Q. What is an Exchange Traded option?
A. An option traded on a regulated exchange where the terms of each option are standardized by the exchange. The contract is standardized so the underlying asset, quantity, expiration date and strike price are known in advance. The benefits to exchange traded options are liquidity of the options, standardized contracts, quick access to prices, and the use of clearing houses by exchanges. The use of clearing houses guarantees the option contract will be fulfilled, while with over-the-counter options the ability to exercise the contract is dependent on the ability of the other party to meet the obligation.
Q. How do I write covered calls?
A. Covered call options can be traded using on-line brokers or traded by telephone with a full service broker. If you have just purchased your shares you may need to trade via telephone. Once the initial share purchase is settled you should be able to trade on-line. On-line trading is usually cheaper.
Risks of Covered Call Options
- Stock market investments carry an inherent level of risk: Writing a covered call requires the investor to own stocks or Exchange Traded Funds; those investment vehicles are stock market investments that are subject to normal market risk. Writing covered calls does provide some downside protection in declining markets. Investors who write covered calls on stocks or Exchange Traded Funds are always in a better position in a declining market than investors who do not write covered calls on those same stocks or Exchange Traded Funds.
- Market gains are capped: The investor who writes covered calls automatically limits his or her potential capital gain to the strike price of the covered call (plus the premium received for writing the covered call.) If the market rises dramatically, the investor may not be able to realize the full benefit of that increase. In volatile markets the writer of a covered call may have been able to reap greater profits by not writing covered calls. The nature of writing covered calls is that potential gains are capped.
- Call options can be exercised at any time: The person who buys a covered call has the right but is not obligated to exercise the option at the strike price at any time during the term of the call. Generally speaking, a covered call written on an ETF will not be exercised if the market price of that ETF is lower than the strike price. While most covered calls are exercised on the expiration date, when the market price is higher than the strike price, the buyer of the covered call can exercise that option at any time. “Losing” the shares early may be unexpected but still benefits the writer of the covered call since the funds received from the sale of those shares can be used or reinvested immediately.
- The option market is not always highly liquid: Options tend to trade in much smaller quantities than common stock or ETF shares. Options for some ETFs are very actively traded, others are much more lightly traded. Variations in trading volume can cause the bid and ask price spread to widen significantly. Placing limit orders (see Writing Covered Calls and Covered Call Glossary for information about limit orders), instead of market orders, ensures an order will not be filled at a different price than what an investor expects.
- Premium prices are subject to market volatility: The price of a covered call option premium is determined by market forces – just like any other investment vehicle. When the market is volatile option premiums tend to be higher than during a stable market. Predicting future volatility is, in short, virtually impossible. If a market becomes less volatile or if the market is less attractive to investors due to a variety of economic factors, option premiums may be lower than they were in the past. Changes in demand and natural market volatility could cause the returns on writing covered calls to be less attractive than during periods of higher volatility or demand.
Check out Writing Covered Calls for a closer look at executing trades.
