If one has to select the most basic of all options trading strategies, the covered call would certainly be one of the strongest contenders. With a covered call an owner of stocks tries to earn a regular income by writing call options against his or her share holdings. A covered call allows the investor to earn a monthly income from the stock investment even if the prices do not move at all.
How to set up a covered call options trade
To set up a covered call, the trader/investor must first own a certain number of shares in the underlying stock. The covered call is then entered into by simply selling one contract of Out of the Money (OTM) options for every 100 shares of the underlying stock.
The risk profile of a typical covered call is illustrated by the green line in Fig. 8.29(b).
From the above chart it become immediately clear that:
a) If the price of the underlying drops significantly, the position will make a substantial loss. See below under profit/loss analysis.
b) If the price of the underlying rises, the position only profits to a limited extent.
c) If the price of the underlying remains stagnant, the position still profits to a certain extent, limited to the amount of premium received on the short calls.
Profit/loss analysis for covered calls
The maximum profit of an ATM covered call position is reached when the share price is precisely at the strike price of the call options on the expiration date. This is presented by point A in Fig. 8.20(b) above.
The formula for calculating the profit at point A = Premium received + strike price of short call – purchase price of the underlying shares.
At any point to the right of point A, the trade will not benefit from additional increases in the price of the underlying and there is another risk: the stocks might be assigned. One should never forget that the person who bought the call options has the right to buy the stocks at the strike price, so when the underlying price moves above that it becomes feasible for the buyer to exercise his rights. In that case the stocks will be called away at the strike price.
There is a ‘hidden’ cost factor here that is seldom discussed in the literature. That is the loss of potential income. If the underlying share price should end above point A in Fig. 8.29(b) and the stock owner had not entered into the covered call trade, he or she would have enjoyed the full benefit of the price increase given by the red line BC in figure. 8.29 (a).
To the downside a covered call is able to absorb small negative price movements before it goes into a loss. This is limited to the premium income received when the call options were sold.
The formula for calculating the loss on a covered call = premium received – difference between closing price and opening price of the underlying shares.
The covered call is certainly not the holy grail of options trading. In fact it has an identical risk profile to that of the much maligned naked put: virtually unlimited risk to the downside and limited profit to the upside. A naked put, on the other side, does not require the trader to first own any stocks.
The biggest benefit for novice traders, however, is that there is no additional margin requirement for this setup, since he or she would already own stocks that can be called away if the options expires In the Money. The fact that the stockowner can benefit even if the
underlying share price remains stagnant also draws many traders/investors to the covered call.