The Equity Strategy Workshop is a collection of discussion pieces. The workshop is designed to assist
individuals in learning how options work and in understanding various
options strategies. These discussions and materials are for educational
purposes only and are not intended to provide investment advice. The inclusion of
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Access to, or
delivery of a copy of, the Options Disclosure Document must
accompany this worksheet.
This segment begins with a list of circumstances that might make selling covered
calls a good investment move.
Who Should Consider Covered Calls?
- An investor who is neutral to moderately bullish on some equities in his
- An investor who is willing to limit his upside potential in exchange for
some downside protection.
- An investor who would like to be paid for assuming the obligation of
selling a particular stock at a specified price.
- An investor who would like to increase income in range-bound markets.
would work equally well for cash, margin, Keogh account or IRA. Although
this strategy may not be suitable for everyone, any of the investors
above may benefit from using the covered call. After reading about Covered Calls, you will have a chance to test your knowledge by using the Covered Call Strategy Worksheet at the bottom of this page.
Covered call writing is either the simultaneous purchase of stock and the sale
of a call option or the sale of a call option against a stock currently
held by an investor. Generally, one call option is sold for every 100
shares of stock. The writer receives cash for selling the call but will
be obligated to sell the stock at the strike price of the call if the
call is assigned to his account. In other words, an investor is "paid"
to agree to sell his holdings at a certain level (the strike price). In
exchange for being paid, the investor gives up any increase in the stock
above the strike price.
How to Use Covered Calls
If an investor is neutral to moderately bullish on a stock currently owned,
the covered call might be a strategy he would consider. Let's say that
100 shares are currently held in his account. If the investor was to
sell one slightly out-of-the-money call, he would be paid a premium to
be obligated to sell the stock at a predetermined price, the strike
price. In addition to receiving the premium, the investor would also
continue to receive the dividends (if any) as long as he still owns the
The covered call can also be used if the investor is
considering buying a stock on which he is moderately bullish for the
near term. A call could be sold at the same time the stock is purchased.
The premium collected reduces the effective cost of the stock, and the investor
will continue to collect dividends (if any) or as long as the stock is
In either case the investor is at risk of losing the
stock if it rises above the strike price. Remember, in exchange for
receiving the premium for having sold the calls, the investor is
obligated to sell the stock. However, as you will see in the following
example, even though the investor has given up some upside potential there can
still be a good return on the investment.
currently is priced at 41.90, and the investor thinks this might be a
good purchase. The three-month 45 calls can be sold for 1.25.
Historically, ZYX has paid a quarterly dividend of 25 cents. By selling
the three-month 45 call the investor is agreeing to sell ZYX at 45
should the owner of the call decide to exercise his right to buy the
stock. Keep in mind that the call owner may exercise the option at any time prior to expiration. If the
stock price is above 45 at expiration, it is likely that the call will be exercised, because the call exerciser will be able to buy the stock for
less than it's current price in the open market. But, as you
will see, his return will be greater than if he had held the stock until
it reached 45 and then sold it at that price.
Let's take a look
at what happens to a covered call position as the underlying stock moves
up or down. Commissions have not been taken into consideration in these
examples; however, they can have a significant effect on your returns.
100 ZYX at 41.90 and Selling 1 Three-Month 45 Call at 1.25. We will
discuss three possible scenarios at expiration.
I. ZYX remains below 45 between now and expiration - call not assigned.
With the stock price below the option's strike price at expiration, the call option will expire worthless. The option premium, the dividends, and the stock
position will be retained. The income for the three-month life of the option, therefore, is 1.50 (the option premium of 1.25 + the dividend of 0.25). This equals 3.5% (1.50/41.90) in three months.
1.25 (Call Premium Received) + 0.25 (dividends received in this example) = Income for 3 Months
1.50 (Income)/41.90 (Stock Price) = 0.035 = 3.5% (percentage income for 3 Months)
The breakeven price is 40.40 (41.90 purchase cost - 1.25 premium for sale of the call - 0.25 dividends received).
When the ZYX call expires worthless, the covered call writer can sell another call going further out in time taking in additional premium. The amount of the future premiums, however, may differ significantly from the premium of the current call price.
If ZYX remains below 45 for an entire year, the investor can sell a total of four calls. Making the hypothetical assumption that the price of the stock and option premiums remain constant throughout the year, the total annual income and the annualized percentage rate of return are calculated as follows:
[1.25 (Call Premium) + 0.25 (Dividends/qtr)] x 4 = 6.00 = Total Income for 12 Months.
6.00 (Income)/41.90 (Stock Price) = 0.143 = 14.3% Annualized Percentage Income
II. ZYX rises above 45 between now and expiration - call assigned.
With the stock price above the strike price of the call at expiration, the call buyer is likely to exercise his right to buy the stock and the call seller
will have to sell ZYX at 45, even though ZYX has risen above 45. But
remember the call seller has taken in the premium of the call and has
been earning dividends (if any) on the stock.
If ZYX stock is
called away at expiration:
||45 for stock
||41.90 stock cost
||4.35 per share*
= 10.4% in three months
* calculations do not include dividends (if any) received.
III. ZYX is right at 45 at expiration.
The covered call writer may be in situation I. or II. The stock may be called
away in which case the call writer will be obligated to sell ZYX at 45.
Alternatively, the stock may not be called away. A call could then be
sold going further out in time, bringing in additional premium and
further reducing the breakeven point.
Writing covered calls is a strategy that has the ability to meet the needs
of a wide range of investors. It can be used in cash, margin, IRA or Keogh accounts, [and calls can be written against stock you already own or stock you are planning to buy.
Currently, there are short-term options listed on more than 1,700 stocks
and more than 200 of those stocks also have LEAPS®, Long-term Equity
AnticiPation Securities, which are simply long-term stock and
index options. Today's investor has a choice of short-term and long-term
expirations, as well as multiple strike prices. The strategy of writing covered calls is
actually more conservative than just buying stock, due to the fact that
you have taken in premium and lowered your breakeven price on the stock
position. The covered write allows you to be paid for assuming the
obligation of selling a particular stock at a specified price.
Covered Call Strategy Worksheet
dividends, margins, taxes and other transaction charges have not been
included. However, they will affect the outcome of option transactions
and should be considered. The strategy discussed above is for
illustrative and educational purposes only and should not be construed
as an endorsement, recommendation or solicitation to buy or sell any
LEAPS® and Long-term Equity
AnticiPation Securities are registered trademarks of the Chicago
Board Options Exchange, Inc.