How to Use Covered Calls
Let's say that an investor holds 100 previously purchased shares of stock, and has either a neutral or slightly bullish market opinion on its price over a given period of time. A call is selected with a strike price, usually out-of-the-money, at which the investor is comfortable selling his shares if assigned, and that can be sold for a premium that provides downside stock price protection that fits his tolerance for risk. The expiration month reflects the time frame of his market opinion. If the investor is particularly bearish on this stock then he might choose another strategy, such as a protective put, which offers more protection from a declining share price. If particularly bullish, then he might choose to leave the stock uncovered for the unlimited upside profit potential that shares offer.
A call could also be written at the same time underlying shares are bought, and the criteria used in considering which call to sell would be similar. Whether the call is written on previously purchased shares, or simultaneously with a new stock purchase, the premium collected reduces the effective cost of the stock. The investor will also continue to collect dividends (if any) as long as the stock is owned.
Writing a Covered Call to Generate Income and Provide Limited Downside Protection
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor has purchased 100 shares of ZYX at a share price of $41.75. He thinks the stock might trade for this amount, or moderately higher or lower, over the near term so he writes an out-of-the-money, three-month ZYX 45 call for $1.25. By selling the $45 call, the investor is agreeing to sell ZYX at $45 should the stock increase above this amount and he is assigned. Participation in a ZYX stock increase is therefore capped at $45 per share.
If the price of ZYX stock declines significantly below the purchase price of $41.75, the investor will incur an unrealized loss on the 100 shares owned. However, this loss can be at least partially offset by the premium of $1.25 per share taken in at the call's initial sale. The break-even point for this strategy is a ZYX price of $41.75 (stock purchase price) - $1.25 (option sale price), or $40.50. In other words, this $1.25 represents the amount of downside price protection on the ZYX shares.
Before option expiration early assignment is always possible. If assignment is received on or before the ex-dividend date then the investor is obligated to sell his 100 ZYX shares and will not be eligible to receive the regular dividend paid to shareholders.
Consider three possible scenarios at expiration:
- ZYX closes below the strike price at expiration
- ZYX closes above the strike price at expiration
- Assignment before expiration