Selling Covered Calls
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.
- You are paid a premium for each call that you sell, and the cash is placed in your account at the time you sell.
- The actual net price of your 100 shares of stock is reduced by the value of the option premium. The covered call discounts your basis because you receive cash when you sell the call. This gives you flexibility and downside protection, as well as greater versatility in selling calls with high time value.
A Premium Deal: You owned 100 shares of Merck that you had originally bought at $38 per share. You sold a covered call shortly after buying the stock at 40 and were paid 3 ($300). However, when the stock rose to $42 per share shortly before expiration, your covered call was exercised. Your stock was called away at the striking price of $40 per share. During the period you owned the stock, you received four quarterly dividends at $38 each. Your total profit on this transaction was:
Profit on stock ($40 less original cost of $38) $200 Call premium received 300 Dividends received 152 Total $652
Discounted Basis: You owned 100 shares of Merck you had originally bought at $38 per share, as in the previous example. You waited a few months until the stock's market value had risen to $42 per share. At that time you sold a covered call with a striking price of 45 and received a premium of 2 ($200). Your <i>net basis</i> is reduced to $36 per share (original cost less premium on the option). While you continue to face the possibility of exercise at $45, that would be nine points higher than your net basis in the stock.
- Selling covered calls provides you with the freedom to accept moderate interim price declines, because the premium you receive reduces your basis in the stock. Simply owning the stock without the discount means that declines in the stock's market value represent paper losses.
ExampleRiding the Price Waves: You own stock originally purchased at $38 per share. Since the purchase date, the price has moved between $38 and $44 per share. When the price was on the high side, you sold covered calls, closing out those positions when the stock's price retreated. You have made a series of modest but consistent profits on the movement in the stock, without having to take profits. The sum of your profits has also reduced your net basis in the stock.
- By selling calls against appreciated stock, you are able to augment profits and, in the case of exercise, build in a capital gain as well.
ExampleTax and Profit Planning: You employ a strategy of buying stock and waiting for price appreciation, and then selling covered calls. If the calls are exercised, you achieve a capital gain on the stock as well as dividend income and option premium. If the calls are not exercised, you augment your current income by closing out those calls at a lower price, or waiting until expiration.
Smart Investor TipThe 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.
ExampleProfit 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.
|Event||Owning Stock and Writing Calls||Owning 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.