The Covered Call

The covered call is one of the most common strategies employed
by individual investors. The covered call writer is moderately bullish to
neutral in his market opinion and is willing to sacrifice some upside gain in
order to collect the premium from the sale of the call contract. The risk of
the underlying stock position is reduced by the amount of the call premium
received. Call premium is received into the investors account as immediate
income. For example an investor may buy 100 shares XYZ stock at $25.00 and
subsequently sell 1 October $30 call at $1.25. At expiration if XYZ is above $30, the investor will have the stock
called away.  When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and
the call premium of $1.25. Her cost basis in the stock is now also reduced to
$23.75, the initial price of the stock minus the premium received for the call.
Numerous academic studies have been done on the covered call strategy and one
of the conclusions drawn from them is that covered call writing can not only
enhance portfolio return, but the strategy has been shown to provide those
returns with lower risk. The volatility of the underlying fund or stock can be
significantly reduced by employing a covered call writing strategy. Since the
delta of an at the money option is 50 and the delta of the underlying fund is
100, if an investor sells an at the money option, the position delta is reduced
to 50, so that position has about half the risk of the underlying position as
long as the option stays at the money, as long as the price of the underlying
does not move very much. Another Greek that the covered call writer wants to
monitor closely is the theta, or rate of decay. The theta tells the option
writer how much money she’ll earn daily just through price erosion. At the
money options will have the highest theta.  Say for example that an investor sells a
slightly out of the money option for $2 at the beginning of the month, not the
first calendar day of the month, but the first Monday following the third
Saturday of the month. If the underlying price stays steady or declines
slightly in the last week of the option’s life it may be only worth 5 cents.
Since the option’s theta is now only 5 cents and the investor has already
earned $1.95 in profit, it may make sense to buy that option back and sell the
following months slightly out of the money option and try to increase the theta
of the holding. In other words attempt to increase the daily income earned
through option decay.

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About sellacalloption

Portfolio manager and chief option strategist for Fusion Asset Management. Professional option trader with VTrader Pro, LLC.

Posted on September 11, 2011, in Covered calls and tagged , , . Bookmark the permalink. 1 Comment.

  1. (Hardcover) If you are ieetrestnd in trading options and have some basic options knowledge, this book is well worth the small investment to gain insight into options trading mechanics. Most options books I have bought do not cover greeks in this amount of detail. When setting up a spread, this book gives a detailed analysis on the effect of each greek in the position. It covers many of the common types of trades.

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