Covered call
From Wikipedia, the free encyclopedia
A covered call is a combination of owning shares of a stock or other securities and selling (or writing) a call option on those shares in corresponding amounts. It has essentially the same payoffs as a short put option on the stock, and thus should have essentially the same price (or premium) as that of a short put (sometimes called a naked put).
A covered call strategy provides income but does not eliminate the downside risk of stock ownership. The potential loss for a covered call is total minus the premium paid. In addition, the strategy limits the potential upside return.
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[edit] Examples
If a trader owns 500 shares of XYZ stock worth $10,000 and sells 5 calls worth $1500, then the first $1500 of decrease in the value of XYZ stock is covered; in other words, the investor does not incur a net decrease in value until after the stock declines by more than $1500. However, the covered call position does not prevent losses should the stock decline by a large amount; it merely reduces those losses. This "protection" is offset by the disadvantage of being forced to sell the stock, if the option is "called out," at below market price or buying back the calls should the price rise above the calls strike price. When the options are subject to being called out before the normal expiration date, many investors using this option will allow the option to be exercised, then simply repurchase the stock and sell more calls at a higher strike price, simply rolling the process over.
If the stock price does not reach the strike price before expiration, the investor may simply repeat the process for the next month if he or she believes the stock will remain on a rising or neutral trend.
Sometimes a covered call is initiated without already owning the underlying stock. If XYZ is trading at 33, and the July 35 call is trading at $1, then one can simultaneously purchase 100 shares of XYZ and sell one call. This requires a net outlay of $3200 compared to $3300 to just purchase the stock. The first $100 ($1 per share) of decline in the stock price is covered by the premium received for the call. Thus the break-even point of this transaction is a stock price of $32. Anything higher results in a profit, anything lower a loss. The upside potential for the above is limited to a maximum of $300 (the $100 received for selling the call and $200 for the increase in the share price to 35) a return of almost 10%. The investor does not automatically participate in any further upside as the call requires the investor to sell at 35, but may repurchase the stock and sell calls at a higher strike price.
To summarize:
| Stock price at expiration |
Net profit/loss | Comparison to simple stock purchase |
|---|---|---|
| $30 | (200) | (300) |
| $32 | 0 | (100) |
| $33 | 100 | 0 |
| $35 | 300 | 200 |
| $37 | 300 | 400 |
[edit] Marketing
Another term for the covered call strategy is a "buy-write" strategy, in that the investor buys stocks and writes call options against the stock position.
According to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005), two developments have enhanced the interest in covered call strategies in recent years: (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. Many new covered call investment products have been introduced since mid-2004.
However, covered calls do not hedge risk, since risk of loss is complete, minus the premium received, and upside is limited
[edit] Examples of Covered Call Investment Products
[edit] References
- Fischer Black, “Fact and Fantasy in the Use of Options.” Financial Analysts Journal 31, (July/August 1975), pp. 36-41, 61-72 .
- Blake, R. "Investors Are Dusting Off an Old Strategy, Options Overlay; When It Works, It Offers Both Yield Enhancement and Risk Management." Institutional Investor, (Sept. 2002), pp. 173 - 174.
- Crawford, Gregory. “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005).
- Feldman, Barry and Dhuv 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.
- Hadi, Mohammed. "Buy-Write Strategy Could Help in Sideways Market." Wall Street Journal. (April 29, 2006) pg. B5.
- 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.
- Moran, Matthew. “Risk-adjusted Performance for Derivatives-based Indexes – Tools to Help Stabilize Returns.” The Journal of Indexes. (Fourth Quarter, 2002) pp. 34 – 40.
- Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management, 7th edition, Thompson Southwestern, 2003, pp. 994-5.
- 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.
- Tan, Kopin, "Yield Boost -- Firms Market Covered-call Writing to Up Returns." Barron's, (Oct. 25, 2004).
- Tergesen, Anne. "Taking Cover with Covered Calls." Business Week, (May 21, 2001), pp. 132.
- Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index" The Journal of Derivatives, (Winter 2002), pp. 35 - 42.
- James W. Yates, Jr. and Robert W. Kopprasch, Jr. "Writing Covered Call Options: Profits and Risks," Journal of Portfolio Management 7 (Fall 1980)
[edit] See also
[edit] External links
- Covered Call
- Options Toolbox
- Covered Call Tables
- Yahoo! Covered Calls
- Covered Calls Worksheet
- CBOE BuyWrite Indexes
- Australian Exchange -- S&P/ASX Buy-Write Index
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