Using Cover Calls to Cut Risk

The strategy of using a covered call is one of the most popular strategies because it is a strategy where the risk is limited. It is a strategy that is used instead of writing naked calls which is highly risky.

Let’s remind ourselves of some option terminology before we look at covered calls. Firstly, a call option gives the buyer the right, but not the obligation, to buy the underlying asset at an agreed price (strike price) on or before an agreed date (expiration). The option buyer pays a premium for this privilege. If the underlying asset is cfd trading above the strike price the option is said to be ‘in-the-money’. If it is trading below the strike price it is said to be ‘out-of-the-money’.

Take for example a buyer of May calls of ABC shares at a strike price of $30 sees that the price of ABC shares in the open market has risen to $35 per share at the end of April. The buyer would exercise the option and take deliver of 100 shares (1 lot) and sell them on the open market for $35 per share, giving the buyer a profit of $5 per share less the premium. The writer of the call however has to go out in the market and buy ABC shares at $35 per share to give them to the option buyer. So the writer is losing $5 per share less the premium he received from the call buyer.

The term covered call refers to the fact that the option writer has the underlying asset in his possession. Therefore unlike the naked call where the writer doesn’t have the underlying asset and is open to unlimited risk, the covered call writer has limited risk.

Suppose for example that you had bought 100 ABC shares at $28 per share. You write May calls for $30 and take a premium of $1 per share. In effect the stock cost is $27 ($28 minus $1 premium). If the market price of the stock is below $30 per share the call will be allowed to expire worthless and you will have the $100 premium in cash. However, if the stock is trading at $31 per share, the option will be exercised and you will have to give the stock to the buyer. The profit on your trade will be $3 per share ($30 minus $28 plus $1 premium). The profit for the writer of the call is in fact capped at $3 whatever the price of the market price of the stock.

The covered call strategy works for stocks that do not move a lot either way and stay pretty much at a consistent level. It does not however work on market bonds.