Just as time is the enemy of a buyer, it is the friend of a seller.
There are two possible outcomes from the covered call:
Key PointTime works against buyers, making long option strategies difficult to execute profitably. However, for covered call selling, the same attribute works in the seller's favor, making covered calls far more profitable in most cases.
- The stock rises above strike. If the stock price is higher than the strike at the point of expiration, the call will be exercised and your 100 shares of stock will be called away at the strike price. With this in mind, the strike you pick for a covered call should always be higher than the price per share you paid to buy the stock. Also remember that a short call can be exercised at any time. The most likely time is the last trading day, which is the trading day (usually Friday unless a holiday) right before the third Saturday of expiration month. Calls might also be exercised on ex-dividend date or at any other time that the call is in the money. Your overall profit consists of the call premium, dividends earned, and capital gains on the stock.You can also avoid exercise with the rolling strategy. This involves closing the short call and replacing it with another call that expires later. This produces more net income because more time equals more premium. It also delays exercise in most cases. If you can roll forward and up to a higher strike, this further reduces exercise risk, or, if the short call is exercised later, a higher capital gain is earned.
- The stock price falls below strike. As long as the stock price remains at or below strike of the short call, that call will not be exercised. You can wait out expiration, after which the call becomes worthless and the premium is 100 percent profit; or you can close out a call and take a short-term profit on the net difference between the original sale and the closing purchase prices. You can open and then close covered calls as often as you wish.
Covered call writing is a conservative strategy because the market risk is lower than the market risk of just owning shares. This is true because the premium you earn from selling the call discounts your net basis in the stock. As long as the strike is higher than the original price per share you paid for the stock, your profit from covered calls that are exercised has three parts: call premium, dividends, and capital gains on the stock. When a call expires or is closed at a profit, you are free to repeat the strategy as many times as you wish.
There are three primary risks to writing covered calls:
Key PointThe risks to covered call writing are fairly low when compared to simply owning shares, because the premium income discounts the stock's basis.
- Your money is tied up for as long as the covered call remains open. You cannot sell shares without exposing the call by converting it to an uncovered call (also called a naked call). While the covered call is low-risk, the uncovered call is very high-risk because in the event of exercise, you would need to make up the difference between strike price and market value of the stock. The other alternative to free up capital is to close the short call, which is not always desirable.
- The call may be exercised. If you open a covered call, you have to be willing to accept exercise and have your 100 shares called away. If you are not willing to give up shares, a covered call is not an appropriate strategy.
- Opportunity for further capital gains is lost. If a covered call is exercised, it means the stock's price moved above the call's strike. No matter how high the price has moved, you are required to deliver your 100 shares at the strike price. A covered call writer has to be completely willing to give up the possible higher appreciation on shares of stock in exchange for the certainty of the call premium.
By Michael C. Thomsett