Rationale for Covered Call Writing
Choosing an Option Strategy
Covered call writing (CCW) is a popular option strategy for individual investors and is sufficiently successful that it has also attracted the attention of mutual fund and ETF managers. Essentially, if you're writing a covered call, you're selling someone else the right to purchase a stock that you own, at a certain price, within a specified time frame.
When CCW is Used
A number of funds adopt covered call writing as their major investment strategy. (We would offer a short list of such funds, but we can not recommend that anyone use them, because they approximate covered call writing, without adopting it fully.)
If you have the time and willingness to trade your own money, then writing covered calls is something to consider. It is not the best investment choice for everyone.
CCW begins with stock ownership and thus, this article is intended to be read by stockholders. The idea is to present the pros and cons of adopting CCW as part of your investment portfolio. CCW can be used by investors who have no current position in the individual stock but would buy shares with the intention of writing call options and collecting the premium.
When writing covered calls, stock selection is the single most important factor in determining your success or failure. Yes, selecting which option to write plays a big role in your performance, but if you own stocks that underperform the markets on a regular basis, then you cannot expect to earn much (if any) money.
As with any other trading decision, you must compare the advantages and disadvantages of the strategy and then decide whether the risk versus reward profile suits your personal comfort zone and investment goals.
Potential Advantages of CCW
Income: When selling one call option for every 100 shares of stock owned, the investor collects the option premium. That cash is yours to keep, no matter what happens in the future.
Safety: It may not be a lot of cash (although sometimes it is), but any premium collected offers the stockholder limited protection against a loss just in case the stock price declines. For example, when you buy a stock at $50 per share and sell a call option that pays a premium of $2 per share, if the stock price declines, you are $2 per share better off than the stockholder who decided not to write covered calls. You can look at it from two equivalent perspectives: The cost basis is reduced by $2 per share, or your break-even price moves from $50 to $48.
The probability of earning a profit increases: This feature is often overlooked, but if you own stock at $48 per share, you earn a profit any time the stock is above $48 when expiration arrives. If you own stock at $50 per share, you earn a profit any time the stock is above $50 per share. Therefore, the stockholder with the lower cost basis (i.e., the person who writes covered calls) earns money more often (whenever the price is above $48 but below $50).
Potential Disadvantages of CCW
Capital gains: When you write a covered call, your profits are limited. Your maximum selling price becomes the strike price of the option. Yes, you get to add the premium collected to that sale price, but if the stock rises sharply, the covered call writer loses out on the possibility of a big profit.
Flexibility: As long as you are short the call option (i.e., you sold the call, but it has neither expired nor been covered) you cannot sell your stock. Doing so would leave you "naked short" the call option. Your broker will not allow that (unless you are a very experienced investor/trader). Thus, although it is not a major problem, you must cover the call option at the same time as, or prior to, selling the stock.
The dividend: The call owner has the right to exercise the call option at any time before it expires. They pay the strike price per share and takes your shares. If that option owner elects to "exercise for the dividend," and if that occurs prior to the ex-dividend date, then you sell your shares. In that scenario, you do not own shares on ex-dividend day and are not entitled to receive the dividend. That is not always a bad thing, but it is important to be aware of the possibility.
CCW as an Option Strategy
CCW can be a good strategy for an investor who is bullish enough to risk stock ownership, but who is not so bullish that they anticipates a huge price increase. In fact, the whole idea behind CCW is a simple trade-off:
The call buyer pays a premium for the possibility of earning 100% of any stock price increase above the strike price.
The covered call seller (writer) keeps the premium. In return all capital gains above the strike price are sacrificed. This contract ends when the option expires.
That's the deal. It is a "love it or hate it" proposition.