Covered Call (Buy-Write)

Covered Call (Buy-Write)

Construction: Buy 100 shares of stock, sell (or write) one call option. By selling the call, you’ll receive immediate cash but have the potential obligation to sell your shares for the call’s strike price. 

Function: Attempting to enhance profitability of stock ownership. It also provides a small downside hedge against adverse stock price movement. If the strategy is used in the long run, the downside hedge increases with the sale of each call.

Bias: Neutral to slightly bullish.

When to Use: When you feel the stock will trade up slightly or in a tight range for a period of time.

Breakeven: Stock purchase price minus the premium received. The premium received acts as a cushion against falling stock prices. The more premiums received, the more the breakeven point is reduced and the larger the hedge.

Max Gain: The maximum gain is limited to the premium received from selling the call plus any capital gains if you sell an out-of-the-money call.

Max Loss: The strategy incurs losses for all stock prices below the breakeven point. The maximum loss is the stock purchase price less the premium received from selling the call.

Key Concepts: If the stock trades up aggressively, your profits are limited by the short call strike price. If the stock price rises above the call strike, you will incur a lost opportunity. Further, if the stock closes above the strike price at expiration, the stock may be called away unless a closing or rolling adjustment is made. The passage of time helps the position. The Covered Call is philosophically identical to the Sell-Write strategy, which works the same way but in the opposite direction.

Example: Buy 100 shares of stock at $50 per share, sell one $50 call for $2, or $200 total. Your net cost is $48 per share, or $4,800. The $2 premium acts as a small downside hedge, so the stock price could fall to $48 and you’d just break even. For all stock prices below $48, you’ll incur losses. Because the stock price could theoretically fall to zero, the maximum loss is also $48. Your maximum gain is the $2 premium received from selling the call (If you sold a higher strike call, say $105, you’d receive less money but be able to make more in capital gains.) If the stock price rises above $50, you won’t participate in those gains since you have the obligation to sell your shares for the $50 strike. If the stock price is greater than the strike at expiration, you’ll lose your shares and receive the strike price in cash ($5,000), which closes out the position. However, you can also choose to roll the call option to another date and collect additional option premiums, which further reduce your cost basis. If the stock price stagnates, your investment continues to grow because of the option premiums collected.

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