The Covered Call – How to Sell a Call

The covered call is one of the most common option market strategies employed by individual investors. The call writing strategy can lower risk and produce income at the same time. The investor will sell a call on her stock position for immediate income. The call money shows up in the account right away. The covered call writer is moderately bullish to neutral in her 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 or call money received. Call premium from the short call 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 also known as the buy write 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 portfolio volatility  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. Shorter term option contracts will  have a higher theta than loner term option contracts.

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. Calls can be written on index options as well as on individual stocks and that is a good way to lower risk by avoiding what is known as company specific risk.

Profit Loss Graph for a Covered Call

SPY Covered Call P/L Graph

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About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on November 6, 2011, in Covered calls and tagged , , . Bookmark the permalink. 1 Comment.

  1. For more about mekrat news, technical analysis and fundamental analysis, see this entry: Do Not use Fundamental Analysis Alone!

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