Equity Option Strategies

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 advertisements on CBOE's website should not be construed as an endorsement of any product, service, or website or as an indication of the value of any claims, recommendations, or other information contained therein. Investment decisions should not be made based upon worksheet outcomes.

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Covered Calls

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 portfolio.
• 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.

The strategy 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.

Definition

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 stock.

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 held.

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.

Stock ZYX 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.

Buying 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:

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.

Summary

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

Commission, 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 particular security.

LEAPS® and Long-term Equity AnticiPation Securities™ are registered trademarks of the Chicago Board Options Exchange, Inc.

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