Showing posts with label call-and-put-options-examples. Show all posts
Showing posts with label call-and-put-options-examples. Show all posts

Sunday, October 13, 2019

Long-Term Options- Introduction

Long-Term Options


Instead, the purpose of this is to highlight the fact that option premiums in general do not reflect the expected long-term growth rate of the underlying equities and to explain an investment strategy that can be used to take maximum advantage of this phenomenon. As I mentioned before, my own interest in this subject stems from the fact that I could no longer contribute additional funds to my retirement plan. As a long-term investor in the market, I had assembled a stock portfolio over many years, and I simply did not wish to raise cash by selling any of my winners. My few losers and laggards had long since been disposed of and the proceeds used to buy more shares of my better-performing stocks. I'm not a short-term, in-and-out investor, but I wanted to keep buying.

Options seemed the way to go, but as with stocks, purchasing calls requires money. What's more, options can only be paid for in cash, so going on margin and borrowing the funds from my broker was out of the question. My next thought was, if I'm going to raise cash, why not sell covered calls on my portfolio? I tried this a few times and promptly had some of my stocks called away from me when their share prices sharply increased as a result of takeover rumors or positive earnings surprises. I wasn't too happy about having to buy back shares using the little cash I had remaining to cover the gap between the exercise price received and the higher repurchase price. So much for covered calls.

By process of elimination, the only strategy remaining was selling puts. This method, you will recall, generates up-front money through the premiums received. Option premiums must be paid on the next business day and are available for reinvestment even faster than proceeds from the sale of stock (which settle within three business days). And because these funds represent premiums paid, not dollars borrowed, they are yours to keep. However, as the fine print in most travel ads states, "certain restrictions apply." Premiums have to stay in your account in case they are needed later in the event of assignment. But because they are in your account, you can use them to acquire additional equities. 

The problem with this approach, I soon discovered, is that applying it to standard options does not bring in much money, especially in relation to the risk assumed in potentially having the underlying stock assigned to you. You can certainly sell a put whose exercise price is well below the current stock price, thereby minimizing the risk of assignment, but doing this brings in a very small premium. A larger premium can be generated by selling a put with an exercise price much closer to or just below the current price, but this can entail significant risk of assignment. Substantial premiums seen on out-of-the-money* puts typically indicate highly volatile stocks or instances where the market (probably correctly) anticipates a sharp drop in the value of the underlying equity—situations that had no appeal to me whatsoever.

And if all that isn't enough, there is also the fact that dealing in standard options, with their quickly changing market values, typically requires substantial, if not full-time, commitment to the task. Most option traders I've met have had little time for anything else during their working days and have often spent a good deal of their evenings and weekends conducting research into what trades to enter and when to cover and get out. This kind of nerve-wracking, nail-biting, glued-to-the-console environment is not what I wanted either. It then occurred to me that there was a solution to this dilemma.

There does exist a class of options whose premiums are relatively large, which bear less risk than standard options, and which, because the underlying equities are comparatively stable, do not have to be monitored with anywhere near the same intensity as standard options. What distinguishes this class of options is their long-term expiration date, which permits the market price of the underlying equity plenty of time to recover should the overall market, industry sector, or the company itself encounter a temporary downturn or adverse conditions. It occurred to me that by selling puts on stronger, well-endowed firms whose intermediate- and long-term prospects are above average, it might be possible to achieve high returns without incurring undue risk.


The class of options that fits this description was actually created by the Chicago Board Options Exchange in 1990. Because standard options expire at most eight months after their inception, the CBOE introduced a new product for investors wishing to hedge common stock positions over a much longer time horizon. These options, called LEAPS (Long-term Equity AnticiPation Securities), are long-term options on common stocks of companies that are listed on securities exchanges or that trade over the counter. LEAPS expire on the Saturday following the third Friday in the month of January approximately two and a half years from the date of the initial listing. 

They roll into and become standard options after the May, June, or July expiration date corresponding to the expiration cycle of the underlying security. In most other ways, LEAPS are identical to standard options. Strike price intervals for LEAPS follow the same rules as standard options (i.e., they are $2.50 when the stock price of the underlying equity is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200). As for standard options, strike prices for LEAPS are adjusted for splits, major stock dividends, recapitalizations, and spin-offs when and if they occur during the life of the option. 

Like standard options, equity LEAPS generally may be exercised on any business day before the expiration date. Margin requirements for LEAPS follow the same rules as standard options. Uncovered put or call writers must deposit 100 percent of the option proceeds plus 20 percent of the aggregate contract value (the current price of the underlying equity multiplied by $100) minus the amount, if any, by which the LEAP option is out of the money. The minimum margin is 100 percent of the option proceeds plus 10 percent of the aggregate contract value. 

LEAP Premiums

Option premiums in general vary directly with the remaining time to expiration. As a result of their longer lives, LEAPS have premiums that can be considerably greater than those of their standard option counterparts. Each entry in the table is the theoretical premium corresponding to the expiration time in months shown in column 1 and the stock volatility, ranging from a fairly low level of 0.15 to a fairly high level of 0.65. Intel's stock, for example, has a volatility of about 0.35, so when the stock price reaches $100, an at-the-money put option should command a premium of $829.60 ($8.296 × 100 shares) with six months to expiration and a premium of $1,313.40 ($13.314 × 100 shares) with 24 months to expiration.

That is, if the stock price and strike price are both $50, the corresponding per share premiums are exactly half the amounts shown. The first question people often ask is why the at-the-money call premiums are so much greater than the corresponding put premiums for the same time horizon and volatility level. Note, for example, that for a stock with a volatility of 0.35 and an expiration date 30 months away, the put premium is $14.035 per share versus $27.964 for the call premium. Is this difference due to general inflation and/or the expected growth rate in the underlying equity?

The answer is no. The reason the call premiums are greater is that option pricing models assume that stock prices are just as likely to increase by, say, 10 percent as they are to decrease by 10 percent on any given day. On a cumulative basis, there is therefore no limit to how high prices can go up over time, but there is a definite lower limit (zero) to how low prices can go. It is this possibility of unrestricted price movement upward versus restricted price movement downward that explains why calls are more expensive than puts.


There is another major advantage associated with LEAPS. Because of the inherently greater premium levels involved, the brokerage commissions charged are going to be a smaller percentage of the proceeds received. At a full-service firm, the brokerage commission to buy or sell a single option might be $45. In percentage terms, this amount is almost 12 percent of the premium for the one-month Intel option, but just 3.2 percent of the premium for the 30-month LEAP option. Commission costs per contract rapidly decrease at a full-service firm if more than one contract is involved and might range from $25 to $35 each for three contracts down to just $15 to $20 each for ten contracts.

At a discount broker's, the commission might be $20 each, but it is typically subject to a minimum fee of $40 and a maximum fee of $70 on transactions involving one to ten contracts. For online, deep-discount, and option-specialized brokers, the commission might be $15 each but is typically subject to a minimum fee of $35 and a maximum fee of $60 on transactions of one to ten contracts.

Table  European-Style At-the-Money Put Premiums as a Function of Time and Volatility

Although there can be significant differences in total commission costs between full-service brokers and other firms, I prefer to work with options-knowledgeable people at a full-service firm. I can readily do this because I am not a short-term investor, and the relatively small number of trades I do per year does not result in significant commissions in terms of absolute dollars. This is particularly true when one remembers that in selling options that subsequently expire worthless, only one commission is involved, not two.

Table  European-Style At-the-Money Call Premiums as a Function of Time and Volatility

LEAPS Available

LEAPS are currently traded on over 300 widely followed equities (as well as on numerous industry sector, domestic, and international indices). Shows the name of the underlying security, its stock symbol, the standard option symbol, the exchange code(s) showing where the option is traded, the options cycle governing when the LEAP option rolls over into a standard option, and the option symbol for the LEAPS expiring in the years 2001 and 2002. Omitted from the table are issues for which no new LEAPS will be listed as a result of mergers and acquisitions that have taken place.

Exchange Codes.

LEAPS are traded on one or more of four major exchanges,* as indicated by the following symbols:

A American Stock Exchange
C Chicago Board Options Exchange
P Pacific Stock Exchange
X Philadelphia Stock Exchange

Expiration Cycles.

These are the January, February, and March cycles that control how and when each LEAP option rolls over into a standard option. It is important to note that the trading symbol for a LEAP option will change when it does roll over and become a standard option, and quote requests, statements, trades, close-outs and exercise instructions should reflect this. In Table, the numerical codes used for the expiration cycles are:

1 January Sequential
2 February Sequential
3 March Sequential

The expiration cycle of a given class of options also tells you the specific month that the corresponding LEAP is due to open for trading. For example, Intel is cycle 1, so the next set of Intel LEAPS is supposed to open right after the May expiration. Boeing is cycle 2, so the next set of Boeing LEAPS is supposed to open right after the June expiration. And Pfizer is cycle 3, so the next set of Pfizer LEAPS is supposed to open right after the July expiration.

LEAP Symbols.

To facilitate trading, LEAPS are symbolized by a four- to six-character trading symbol made up of a root symbol designating the underlying equity, a single character designating the expiration month, and a single letter designating the strike price involved. Because LEAPS expire only in January, the code letter for the expiration month is always A for calls and M for puts. The root symbols for the underlying equity began with the letter V for the January 1999 LEAPS and the letter L for the January 2000 LEAPS, and begin with the letter Z for the January 2001 LEAPS and the letter W for the January 2002 LEAPS. This V/L/Z/W sequence of initial letters is repeated every four years, so the letter V will likely be assigned as the starting letter for the year 2003 LEAPS.

As each LEAP option rolls over into a standard option approximately a half year prior to expiration, the root symbol portion of the trading code is changed to that of the standard option. Because of conflicts that frequently arise with existing trading symbols of stocks and standard options, there is often no consistency in the designations of LEAP root symbols. Note too that although the LEAP root symbols are three letters long, in some instances they consist of just two letters. A dash indicates that there was no LEAP option offered for that year on a particular security, often because of a pending merger or acquisition.

It is frequently the case that as a result of a wide fluctuation in stock price (as well as mergers, acquisitions, and stock splits), there is going to be more than one LEAP root symbol for a given stock and expiration year. For example, the January 2001 LEAPS for Yahoo have the root YZY for strikes between $22.5 and $35; ZYH for strikes $37.50 through $85; ZGH for strikes $90 through $135; ZYO for strikes $150 through $200; and ZYM for strikes between $210 and $250. The only sure way to determine the correct root symbol for a given LEAP option series is to consult an online table showing the specific LEAPS available, such as the one maintained by the Chicago Board Options Exchange. Or you can call the CBOE directly at 800-OPTIONS (678-4667).

Position Limits.

Not shown in Table because of rapidly changing conditions is the maximum number of open contracts that are permitted on any option class. As opposed to stocks, whose outstanding shares often number in the hundreds of millions, the maximum number of open option contracts (including LEAPS and standard options) permitted on the underlying equity is heavily limited. These limits are set in accordance with the number of outstanding shares and the trading volume of the underlying equity.

The larger, more frequently traded stocks are assigned initial position limits of 75,000 contracts, while less active issues are assigned initial position limits of either 60,000, 31,500, 22,500, or as few as 13,500 contracts for the smallest of traded issues. As a result of stock splits, mergers, acquisitions, and other factors, these limits are periodically adjusted. Position limits are imposed by the various options exchanges to prevent any person or entity from controlling the market on a given issue. Because every option contract has both a buyer and a seller, the open contract count is the sum of the number of opening calls bought and the number of opening puts sold, so as not to double count.

Using Options to Buy Stocks

There's no way around it, buying stocks takes money. But by now you've guessed where the money for buying stocks can come from: not out of your pocket but from the premiums accumulated from the sales of the LEAP puts. As described in the preface, the purpose of my selling LEAP puts was not just to enhance the cash flow and dividend yield of my stock portfolio. Rather, it was to furnish the funds with which to continue stock acquisition.

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

 Table  LEAPS Available August 1999

Table  LEAPS Available August 1999 

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

Friday, September 20, 2019




In the long call strategy, you are purchasing the right, but not the obligation, to buy the underlying shares at a specific price until the expiration date. This strategy is used when you anticipate an increase in the price of the underlying stock. A long call strategy offers unlimited profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to increase in price.

When the underlying security price rises, you make money; when it falls, you lose money. This strategy provides unlimited profit potential with limited risk. It is often used to get high leverage on an underlying security that you expect to increase in price. Zero margin borrowing is allowed. That means that you don’t have to hold any margin in your account to place the trade. You pay a premium (cost of the call), and this expenditure is your maximum risk.

Perhaps the only drawback is that options have deadlines, after which you cannot recoup the premium it cost to buy them. Thus, you need to buy calls with enough time till expiration for the underlying to move into the profit zone—at least 90 days—or simply purchase LEAPS with a year or two until expiration. In addition, it’s best to buy calls with low implied volatility to lower the breakeven and minimize the debit to your account.

FIGURE  Long Call Risk Graph

Long Call Mechanics

In this example, let’s buy 1 March XYZ 50 Call @ 5.00, with XYZ trading at $50. This trade costs a total of $500 (5 × 100 = $500) plus commissions. The maximum risk is equal to the cost of the call premium or $500. The maximum reward is unlimited to the upside as underlying shares rise above the breakeven. The breakeven is calculated by adding the call premium to the strike price. In this example, the breakeven is 55 (50 + 5 = 55), which means the underlying shares have to rise above 55 for the trade to start making a profit. 

In Figure, note how the numbers that run from top to bottom indicate the profit and loss of this trade. The numbers that run left to right indicate the price of the underlying asset. The sloping line indicates the theoretical profit or loss of the call option at trade expiration according to the price of the underlying asset. Note how the loss is limited to the premium paid to purchase the call option.

The risk graph of the long call shows unlimited profit potential and a limited risk capped at $500. The breakeven is calculated by adding the call premium to the strike price. The long call breakeven is slightly higher than the breakeven on the stock, but this is the trade-off a trader takes for opting for a position with less risk and a higher return on investment.

Exiting the Position

A long call strategy offers two distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares, although volatility can have a major impact as well.

XYZ rises above the breakeven (55): Offset the position by selling a call option with the same strike price and expiration at an acceptable profit; or exercise the option to purchase shares of the underlying market at the lower strike. You can then hold these shares as part of your portfolio or sell them at a profit at the current higher market price.
XYZ falls below the breakeven (55): If a reversal does not seem likely, contact your broker to offset the long call by selling an identical call to mitigate your loss. The most you can lose is the initial premium paid for the option.

In this example, let’s say XYZ rises 10 points to 60. There are two ways to take advantage of it: exercise or offset it. By exercising the March 50 call, you will become the owner of 100 shares of XYZ at the lower price of $50 per share. You can then sell the shares for the current price of $60 a share and pocket the difference of $1,000. But since you paid $500 for the option, this process reaps only a $500 profit ($1,000 – $500 = $500) minus commissions. The more profitable technique is to sell the March 50 call for the new premium of 14.75, an increase of 9.75 points. By offsetting the March 50 call, you can make a profit of $975 ($1,475 – $500 = $975)—a 195 percent return!

Conversely, if you had bought 100 shares of XYZ at $50 per share, you would have made a profit of $1,000 (not including commissions) when the shares reached $60 per share—an increase of 10 points. The profit on the long stock position is slightly higher than the profit on the long call—a big $25. However, the return on investment is much higher for the long call position because the initial investment was significantly lower than the initial capital needed to buy the stock shares. While both trades offered profit-making opportunities, the long call position offered a significantly lower risk approach and the power to use the rest of the available trading capital in other trades. 

For an initial investment of $5,000, you could have purchased 10 call options and made a total profit of $9,750—now, that’s a healthy return. The ability of a call option to be in-the-money by expiration is primarily determined by the movement of the underlying stock. It is therefore essential to know how to analyze stock markets so that you can accurately forecast future price action in order to pick the call with the best chance of making a profit. Understanding market movement is not an easy task. Although it takes time to accumulate market experience, you can learn how various strategies work without risking hard-earned cash by exploring paper trading techniques.

Long Call Case Study

In order to illustrate how the long call works in the real world, let’s consider an example using a familiar name—Intel (INTC). Suppose you were studying some research notes on Intel and it seemed to you that the stock price had fallen too far given the outlook for the company’s semiconductor sales. The chart pattern also seemed to suggest that the stock was due to move higher. With shares trading near $15.75, you expect it to move above $20 by year-end. So, you decide to establish a bullish trade on the chipmaker.

Instead of buying shares, you decide to buy the INTC January 17.50 call. That is, you will buy the call option on Intel that has the strike price of 17.50 and has an expiration month of January. The current premium is $2.55 per contract and you buy 10 contracts. The total cost of the trade is therefore $2,550: (2.55 × 10) × 100 = 2,550. Since Intel is trading near $16 a share at the time, this call is out-of-the-money. Many call buyers prefer to use out-of-the-money calls because they provide the most leverage. It is a very aggressive way to trade the market.

To calculate the breakeven, we add the option’s strike price to the contract price, or 17.50 plus 2.55. The breakeven equals $20.05 a share. Often, traders will exit the long call strategy before expiration if the stock moves dramatically higher or falls too far below the breakeven. Recall that time decay is the greatest during the last 30 days of an option’s life. Therefore, it is best not to hold an option like the long call during that time. In addition, many traders will exit the position if it does not move in the anticipated direction. 

For example, if INTC drops below $15 a share, the trader might choose to close the trade. In that case, the $15 level would be considered a stop loss, or a predetermined price point where the trader exits a losing trade. In any case, rarely will the long call be exercised when it is purchased in anticipation of a move higher in the underlying security. Instead, the position is closed through an offsetting transaction. Specifically, you will sell 10 INTC January 17.50 calls to close.

We can see that if the stock falls the call will lose value. In contrast, profits begin to build as the stock moves higher. The maximum risk is equal to the premium, or $255 per contract. The upside potential is quite large. In fact, in this case, Intel not only rose above $20 a share that year, it topped $30. As a result, by the end of the year, the INTC January 17.50 call was worth $17.50 a contract—for an 11-month 600 percent gain!

FIGURE  Risk Graph of Long INTC Call 

Long Call versus Long Stock

As you can see, a long call strategy has many advantages compared with buying stock. For clarity’s sake, let’s review these advantages.

Cost. The premium of an option is significantly lower than the amount required to purchase a stock.
Limited risk. Since the maximum risk on a long call strategy is equal to the premium paid for the option, you know before entering the trade exactly how much money you could potentially lose.
Unlimited reward. Once you hit breakeven (call strike price + call option premium = breakeven), you have unlimited reward potential as in a stock purchase.
Increased leverage. Less initial investment also means that you can leverage your money a great deal more than the 2-for-1 leverage buying stock on margin offers.

The only drawback is that options have a limited time until they expire. But even this disadvantage can be seen as an advantage if you consider the opportunity cost of waiting months and sometimes years for a stock that has taken a bearish turn to reverse direction.


In a short call trade, you are selling call options on futures or stock contracts. This strategy is placed when you expect the price of the underlying instrument to fall. If you want to short a stock, your risk curve would fall from the upper left-hand corner to the lower right-hand corner. Notice how the horizontal line slants upward from right to left, providing insight as to its bearish nature. When the underlying instrument’s price falls, you make money; when it rises, you lose money. This strategy provides limited profit potential with unlimited risk.

It is often used to get high leverage on an underlying security that you expect to decrease in price. Selling a call enables traders to profit from a decrease in the underlying market. If the underlying stock stays below the strike price of the short call until the option’s expiration, the option expires worthless and the trader gets to keep the credit received. But if the price of the underlying stock rises above the short call strike price before expiration, the short option will be assigned to an option buyer.  A call buyer has the right to buy the underlying asset at the call strike price at any time before expiration by exercising the call. 

If the assigned call buyer exercises the option, the option seller is obligated to deliver 100 shares of the underlying stock to the option buyer at the short call strike price. This entails buying the underlying stock at the higher price and delivering it to the option buyer at the lower price. The difference between these two prices constitutes the seller’s loss and the buyer’s open position profit. This can be a huge loss in fast markets, which is why we never recommend selling short, or “naked,” options.

FIGURE  Short Call Risk Graph

Selling naked calls is not allowed by many brokerages. Some may require you to have at least $50,000 as a margin deposit. This speaks volumes about just how risky this strategy can be. However, since a short call is very useful in hedging and combination options strategies, it is important to understand its basic properties. In the case of selling options, be advised that you will initially receive money into your account in the form of a credit. This is the premium for which you sold the option. 

This strategy is used to generate income from the short sale of an option, since it provides immediate premium to the seller. In addition, it’s best to short calls when the implied volatility of the option is high; that way, you maximize the premium received. This is vital since the profit on a short call is limited to the premium received, and the position has an unlimited upside risk. As you can see by looking at the risk, this is a very risky strategy because it leaves the trader completely unprotected.

Short Call Mechanics

Let’s create an example that shows the trader going short 1 Jan XYZ 50 Call @ 5.00. The trader collected $500 (5 × 100 = 500) minus commissions for this trade. The maximum reward is limited to the credit the trader receives at the trade’s initiation. Conversely, the risk on this trade is unlimited as the price of the underlying asset rises above the breakeven. The breakeven of a short call equals the strike price of the call option plus the call premium. 

In this trade, the breakeven at expiration is 55: (50 + 5 = 55). As the market drops, the position increases until it hits the maximum credit (i.e., the amount of premium taken in for the call. Please note that a short call comes with unlimited risk to the upside. It is very important that you learn how to create covered positions (i.e., sell an option and buy an option) to limit your risk and protect against unlimited loss.

When the underlying stock reaches a price of 50, the position’s profit hits a maximum of $500 (the credit received). The call’s potential loss is unlimited and continues to increase as the price of the underlying asset rises above the $55 breakeven. If the market price of the underlying asset doesn’t rise, you get to keep the credit. However, this is the most that can be made on the trade.

Exiting the Position

A short call strategy offers three distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares.

• XYZ falls below the call strike price (50): This is the best exit strategy. The call expires worthless at expiration. This means you get to keep the premium, which is the maximum profit on a short call position.
• XYZ rises above the call strike price (50): The call will be assigned to a call holder. In this scenario, the call seller is obligated to deliver 100 shares of XYZ at $50 per share to the assigned option holder by purchasing 100 shares of XYZ at the current market price. The difference between the current market price and the delivery price of $50 a share constitutes the loss (minus the credit of $500 initially received for shorting the call).
• XYZ starts to rise above the breakeven (55): You may want to offset the position by purchasing a call option with the same strike price and expiration to exit the trade because assignment becomes increasingly likely once the time value of an option falls below 1/4 point.

Short Call Case Study

When looking for short call candidates, what we want to see is a stock that has run into resistance and that is expected to move lower before option expiration. Since we are selling the call, we also want to use time decay to our advantage by selling front month options. Lastly, we are looking for a stock that has options that are showing high implied volatility (IV) compared to the past. The higher the IV, the larger the premium we receive up front. Let’s look at a real-world example for a short call.

In late May 2003, we could have run a search for stocks that had options showing high implied volatility. One stock that would have shown up was Northrop Grumman (NOC). On May 26, NOC spiked higher, but ran into resistance near $90. By entering a short call, we have unlimited risk to the upside. This means that if the stock moves sharply higher, we have to come up with the money to cover the call. However, we get a credit immediately from the sale of the call, though margin will be needed. 

In our example, NOC was at $87.96 as of the close of trading on May 27. At that time, we could have sold the June 90 call for $1.10, or $110 per contract. In this case, our maximum risk is unlimited as the stock rises and our maximum profit is the initial credit received. Our breakeven point is found by adding the credit we received (1.10) to the strike price of 90: (1.10 + 90 = 91.10). Thus, the breakeven point as of expiration is at $91.10.

FIGURE  Risk Graph of NOC Short Call 

This occurs because the trade has unlimited risk as the stock rises. For most traders, this type of trade is too risky to undertake and it requires a lot of capital to be held in margin. Nonetheless, for the trader who has the funds and uses appropriate money management, a short call can be profitable. In our example, shares of NOC remained below $90 all the way through June expiration on June 20. In fact, the stock was making a move higher when expiration hit, but this trade still would have closed with a maximum profit of $110 per contract.


Covered call writing (selling) is the strategy that seems to be promoted most by the investment community. Many stockbrokers use this technique as their primary options strategy, perhaps because it is the one technique they are trained to share with their clients. It is also widely used by many so-called professional managers. Nevertheless, it can be a dangerous strategy for those who do not understand the risks involved. A few publications describe this technique as a “get rich quick” method for investing in the stock market, but it can become a “get poor quick” strategy if done incorrectly.

What is this technique all about? The purpose of the covered call is to increase cash income from a long stock or futures position. It provides some protection against decreases in the price of a long underlying position or increases in the price of a short underlying position. A covered call has limited profit potential and can result in substantial losses; but these potential losses are less than those for an unprotected long stock or futures position. A covered call write is composed of the purchase of a stock (or futures contract) and the sale of a call option against the purchased underlying asset. 

Remember, the buyer of a call option has the right to call the option seller (writer) to deliver the stock at the price at which the option was purchased. Therefore, if you write an option you are the seller, and you are responsible for delivering the stock at the strike price at which the option was sold to the purchaser if the option is exercised. At the inception of the transaction, you receive a premium, which pays you for the time value of the option as well as any intrinsic value the option may have at that time. You may be wondering what is wrong with the whole concept of covered call writing. 

Why are so many people incorrect when they use this strategy? Many traders simply do not know the risks they are assuming when they implement this overused technique. If you placed covered calls in stocks that only go up, you could make out very well. However, how many people pick stocks that only go up? A range-bound stock exhibits price action between two specified points: resistance and support. Resistance is the point at which prices stop rising and tend to start to drop. Support is the point at which prices stop dropping and tend to start to rise. 

When a stock rises, it hits a certain price where the sellers rush in, outnumbering the buyers, and thereby causing prices to start to fall off. The support level is the place where the price has become low enough for buyers to start to outnumber the sellers and the price begins to rise again. If this recurs over a specified period of time (e.g., six months), strong support and resistance levels have probably been established. Stocks that exhibit these tendencies can be excellent candidates for covered call writing. However, you must be aware that nontrending stocks also can begin trends, and many may begin trending to the downside.

Covered Call Mechanics

Let’s create a hypothetical example using a technology stock with the name XYZ Computer Corp. The ticker symbol for shares is XYZ and the company is one of the world’s leading computer sellers. The company has performed exceptionally well, with shares rising more than 400 percent in a one-year period! Let’s say XYZ Computer is trading at $49 per share after numerous stock bonuses, and we decide to place a covered call trade. Let’s buy 100 shares of XYZ at $49 each. This part of the trade costs $4,900 ($49 × 100 = $4,900). The amount of margin (the capital required) would be half this amount, or $2,450. 

In a covered call strategy, a trader offsets the purchase cost of shares with the sale of a call option. The covered call consists of selling one call for each 100 shares owned. The call can have any strike price and any expiration; however, this step can be difficult. You have to choose which option to sell.  You have a multitude of choices: near-term, long-term, in-the-money, out-of-the-money, at-the-money, and so on. Many covered call writers sell options one or two strikes out-of-the-money (OTM) because they want the shares to have a little room to run up before reaching the strike price at which the option was sold. 

Let’s say that on September 9, XYZ is trading at $49, and the October 50 and 55 call options (which have 40 days to expiration) have the following option premiums:

• October 50 Call @ 2.75.
• October 55 Call @ 1.75.

In this example, let’s go long 100 shares of XYZ at $49 and short 1 XYZ October 50 call at $2.75. This transaction has two sides, the debit (purchase of shares) and the credit (sale of option). The debit equals $4,900 ($49 × 100 = $4,900); however, the amount of margin (the capital required to place the trade) would be half this amount, or $2,450. In addition, you would receive a $275 credit (2.75 × $100 = $275) for the short option on 100 shares of stock.

If the stock rises from $49 to $50, the strike price of the option, you make an additional $100. You also get to keep the $275 credit you received. In total, your profit will be $375. If the stock goes to $55 you still get $375. If the shares go to $100 you still get only $375. In both these instances, you have to deliver the shares to the assigned purchaser of the option as it will be exercised at expiration since the option is in-the-money (i.e., the share price is greater than the strike price of the option).

Figure  Covered Call Risk Graph

That means that for an investment of $2,075: ($2,450 – $375 = $2,075), you can make $375 if the stock rises to at least $50 by expiration—a 17 percent return in only 40 days. Lastly, the breakeven of a covered call is calculated by subtracting the credit received on the short call from the price of the underlying security at trade initiation. In this trade, the breakeven is 46.25: (49 – 2.75 = 46.25).

In Figure, the risk graph for the covered call example, notice how the profit line slopes upward from left to right, conveying the trader’s desire for the market price of the stock to rise slightly. It also shows the trade’s limited protection. As XYZ declines beyond the breakeven (47.25), the value of the stock position plummets as it falls to zero. Thus, the inherent risk in this strategy rears its ugly head.

Overall, the covered call offers a slightly better approach than if you simply purchase the stock at $49 and watch it drop, because you have reduced your breakeven price by 2.75 points. XYZ must drop below this new breakeven price (46.25) to start losing money at expiration. But once it falls below the breakeven, losses can accumulate quickly. Now let’s say you sell the October 55 calls at 1.75; then your breakeven price is higher at $47.25 ($49 less the 1.75 received for selling the 55 call).  By selecting the higher strike call option to sell, you will receive less of a credit and will raise your breakeven price for the stock. 

However, then you have a greater potential return on the investment if and when the stock goes up. Obviously, you lose money when the stock goes below the breakeven price. Bottom line: each option has a certain trade-off for the option writer. You have to decide which one best fits the market you are trading. As mentioned previously, if the price of XYZ stock has been going up significantly over the past year, covered call writing would not have hurt you. You may not have received the 400 percent gain stock purchasers received, but perhaps you could have slept better at night, as you would have reduced your breakeven point. 

Unfortunately, traders may select stocks that have just begun a tailspin and lose 50 percent of their value overnight. In these cases, a covered call strategy will not help. These traders may get to keep the short option’s credit, but that will not go very far in light of losing 50 percent or more on the total price of the stock. There are numerous examples of companies losing 30 percent, 40 percent, 75 percent, or all their value in one day. Do not count on this strategy to save you from losing large sums of money if the stock makes a big drop. Writing covered calls can work. 

However, you must find stocks that meet one of two criteria: trending upward or maintaining a trading range. As exhibited with XYZ, covered calls work well with stocks on the rise.  Unfortunately, even stocks with upward trends have moments in which they make sharp corrections.  These periods are difficult for covered call writers as they watch their accounts shrink, because the covered call does not offer comprehensive protection to the downside. However, in many cases good stocks will rebound. 

If you do choose to write covered calls, do so only in high-grade stocks that have been in a consistent uptrend and have exhibited strong growth in earnings per share. To protect yourself from severe down moves, you can combine covered calls with buying puts for protection. If you purchase long-term puts (over six months), you can continue to write calls month after month, but you will have the added protection of the right to sell the underlying stock at a specific price.

Exiting the Position

Since a covered call protects only a stock within a specific range, it is vital to monitor the daily price movement of the underlying stock. Let’s investigate optimal exit strategies for the first covered call example, the sale of the 50 call.

• XYZ rises above the short strike (50): The short call is assigned. Use the 100 shares from the original long stock position to satisfy your obligation to deliver 100 shares of XYZ to the option holder at $50 a share. This scenario allows you to take in the maximum profit of $375.
• XYZ falls below the short strike (50), but stays above the initial stock price (49): The short call expires worthless and you get to keep the premium ($275) received. No losses have occurred on the long stock position and you can place another covered call to offset the risk on the long stock position if you wish.
• XYZ falls below the initial stock price (49), but stays above the breakeven (46.25): The long stock position starts to lose money, but this loss is offset by the credit received from the short call. If XYZ stays above 46.25, the position will break even or make a small profit.
• XYZ falls below the breakeven (46.25): Let the short option expire worthless and use the credit received to partially hedge the loss on the long stock position.

Covered calls are one of the most popular option strategies used in today’s markets. If you want to gain additional income on a long stock position, you can sell a slightly OTM call every month. The risk lies in the strategy’s limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. Covered calls can also be combined with a number of bearish options strategies to create additional downside protection.

Covered Call Case Study

Covered calls are often used as an income strategy on stocks that we are holding long-term. They also can be used as a short-term profit maker by purchasing the stock and selling the call at the same time. The idea is to sell a call against stock that is already owned. If we do not want to give up the stock, we must be willing to buy the option back if it moves in-the-money. 

However, if we feel the stock will not rise above our strike price, we would benefit by selling the call. On December 1, 2003, shares of Rambus (RMBS) were falling back after an attempt to break through resistance at $30. The stock rose to a high of $32.25, but ultimately ended flat on the session right at $30 a share. Viewing the chart, we might have decided that $30 would hold and that entering a covered call strategy might work well.

By entering a short call, we have unlimited risk to the upside. However, by owning the stock, we mitigate this risk because we could use the stock to cover the short call. Let’s assume we didn’t already own Rambus, so we need to purchase 500 shares at $30 and sell 5 December 30 calls at $2.05 each. Our maximum profit for this trade is $1,025 [(2.05 × 5 ) × 100] and this occurs if the stock is at or above 30 on December 19. The maximum risk is still large because the amount of the credit for selling the calls does little for a major drop in the stock. 

Our breakeven point is at 27.95, which is figured by taking the credit received and subtracting it from the price of the underlying at trade initiation (30 – 2.05). Though we have limited our upside risk by using stock to cover the short call, we still have significant risk to the downside if the stock were to fall sharply. However, if the stock remains near $30, we get to keep the entire credit, even though there wasn’t a loss in the shares of stock. Since the passage of time erodes the value of the option, it’s best to use short-term options.

In our example, shares of RMBS did try several times to break higher, but each time resistance held and the stock ultimately closed at $26.37 on expiration December 19. At expiration, the stock position was down $3.63 a share, or $1,815: (3.63 × 500). However, the loss was offset by the $1,025 received from the credit from the short calls. So, the trade results in a $790 loss. A trader could continue to sell calls against the stock each month if it is felt the stock will remain near the strike price.

FIGURE  Risk Graph of Covered Call on RMBS