Selling Covered Calls

When you sell uncovered calls, potentially large losses can result if you are required to deliver shares upon exercise, or to close out positions at a loss to avoid exercise. Imagine being able to sell calls without that risk -- meaning that you would never be required to suffer large losses due to an unexpected rise in the stock's market value.

There is a way. By selling a call when you also own 100 shares of the underlying stock, you cover your position. If the option is called away by the buyer, you can meet the obligation simply by delivering shares that you already own.

You enjoy several advantages through the covered call.The disadvantage to covered call selling is found in lost opportunity risk that may or may not materialize. If the stock's market value rises dramatically, your call will be exercised at the specified striking price. If you had not sold the call, you would benefit from higher market value in shares of stock. So covered call sellers trade the certainty of premiums received today, for the potential lost profits in the event of exercise.

Smart Investor Tip

The major risk associated with covered call writing is the possibility of lost income from rising stock prices. But that might not happen at all; when you sell a call, you accept the possibility of lost capital gains income in exchange for the certainty of call premium income.


Profit Alternatives, a Nice Dilemma: You own 100 shares of stock, which you bought last year at $50 per share. Current market value is $54 per share. You are willing to sell this stock at a profit. You write a November 55 call and receive a premium of 5. Now your net basis in the stock is $45 per share (original price of $50 per share, discounted five points by the option premium). If the stock's market value remains between the range of $45 and $55 between the date you sell the call and expiration, the short call will expire worthless. It would not be exercised within that price range, since striking price is 55. You can wait out expiration or buy the call, closing it out at a profit. However, if the stock's value does rise above $55 per share and the call were exercised, you would not receive any gain above $55 per share. While exercise would still produce a profit of $1,000 ($500 stock profit plus $500 option premium), you would lose any profits above the striking price level.

One of three events can take place when you sell a covered call: an increase in the stock's price, a decrease in the stock's price, or no significant change. As long as you own 100 shares of the underlying stock, you continue to receive dividends even when you have sold the call. The value of writing calls should be compared to the value of buying and holding stock, as shown in Table.

Comparing Strategies

EventOwning Stock and Writing CallsOwning Stock Only
Stock goes up in value.Call is exercised; profits are limited to striking price and call premium.Stock can be sold at a profit.
Stock remains at or below the striking price.Time value declines; the call can be closed out at a profit or allowed to expire worthless.No profit or loss until sold.
Stock declines in value.Stock price is discounted by call premium; the call is closed or allowed to expire worthless.Loss on the stock.
Dividends.Earned while stock is held.Earned while stock is held.

Before you undertake any strategy, assess the benefits or consequences in the event of all possible outcomes, including the potential for lost future profits that might or might not occur in the stock. To ensure a profit in the outcome of writing covered calls, it is wise to select those calls with striking prices above your original basis, or above original basis when discounted by the call premium you receive.


The Discounting Effect: You bought stock last year at $48 per share. If you sell a covered call with a striking price of 50 and receive a premium of 3, you have discounted your basis to $45 per share. Given the same original basis, you may be able to sell a call with a striking price of 45 and receive a premium of 8. That discounts your basis to $40 per share; in both instances, exercise would net a profit of $500. (Exercise at $50, discounted basis of $45 per share; or exercise at $45, discounted basis of $40 per share.) In the latter case, chances of exercise are greater because the call is five points deeper in the money. Selling out-of-the-money calls also affects your capital gain, so if your profit in the stock is substantial, this strategy could be expensive; if you lose the long-term gain status in the stock, it could offset the overall pretax gain. (See Risk and Taxes: Rules of the Game for more information concerning taxes and covered calls.)

In comparing potential profits from various strategies, you might conclude that writing in-the-money calls makes sense in some circumstances, even with possible tax consequences in mind. A decline in the stock's price reduces call premium dollar-for-dollar, with the added advantage of declining time value. If this occurs, you can close out the position at a profit, or simply wait for exercise. As a call seller, you are willing to lock in the price of the underlying stock in the event of exercise; this makes sense only if exercise will produce a profit to you, given original purchase price of the shares, discounted by the call premium, and given the net tax consequences involved.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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