Common Terms Used in the Covered Call Writing Process

Strike price It is the pre-determined stock price mentioned in the covered call contract at which the transaction is to take place irrespective of the prevailing market price of the underlying stock.

Option premium The payment made by a covered call option buyer to the option writer for holding a right to exercise the option at the strike price before the expiration date of the contract.

Expiration date The date after which the option contract automatically becomes null and void.

Call Writer A person who sells/offers a covered call option to the buyer.

In-the-money covered call If the prevailing market price of the underlying stock is higher than the strike price of the option contract, the covered call option is said to be in-the-money.

At-the-money covered call If the prevailing market price of the underlying stock is equal to the strike price of the option contract, the covered call option is said to be at-the-money.

Out-of-the-money covered call If the prevailing market price of the underlying stock is lower than the strike price of the option contract, the covered call option is said to be out-of-the-money.

Time Value Decay Since an options contract is a function of time, it is essentially a decaying asset. It loses its value as the time passes by. This loss in value with time is termed as the Time Value Decay. Time is always against the option buyer and in favor of the option writer (seller).

The Nature and Advantages of Covered Call Writing

A covered call option is different from an ordinary call option since the option writer already owns the underlying security assets. This is where the name covered call option is derived. The option contract is covered by the stock already owned by the option writer. The stock held by the option writer acts as a kind of collateral to the option contract. From the buyers point of view, a covered call is desirable because in case he decides to exercise his option, he can rest assured that the option writer will transfer the underlying security to him at the agreed strike price.

Covered calls also reduce the risk of default of security transfer by the option writer and act as a guarantee for the option buyer. This leads to increased security and reliability in the trading system as a whole. Covered calls are desirable from the option writers point of view since he doesnt have to purchase the underlying securities at the market price in case an option holder decides to exercise the option. This way, the stock held by the option writer acts as a security and also helps in the reduction of losses, if any. There are two parties to a covered call option contract, the seller of the option, who is also called the writer, and the buyer of the option who gets the right to exercise the option in lieu of a payment of premium to the writer. Hence, this instrument is in favor with those who like to keep their risk exposure to a minimum while also getting an assured return.

Differences From Stock Investing

Covered call writing requires relatively higher expertise compared to investing in plain vanilla stocks.

Stocks constitute simple investments while covered calls are derivatives based on the underlying financial instruments.

Stock investing is a buy low sell high strategy while covered call writing is an all weather financial instrument.

The stock investors favor a bullish market scenario while covered call options are in vogue irrespective of the prevailing market sentiments.

Stock Investing refers to a process of using funds to purchase the shares of different companies in the hope of getting superior returns on the investment. The underlying principle of stock investing is to buy low and sell high while the covered call writing process tries to create a win-win situation for the call writer. Investors buy shares when they are trading below their market value or are under valued for the time being. These shares are subsequently held till their market prices reach a fair (high) value. On the other hand, by writing covered calls, a trader stands to earn by way of premium even when the markets are trading low.

Description of a Covered Call Transaction

In a covered call, the buyer and the seller (writer) agree to transact a particular stock at a particular day at a price that is referred to as the strike price. The buyer purchases the option (right to buy) by paying the premium to the writer. If the stock price shoots up the strike price, the buyer exercises the option and makes a profit. However, if the stock price goes below the strike price, the buyer doesnt exercise the option and the writer earns the premium.

Suppose a stock Acme is trading at $13 and the strike price is $15. Suppose the stock price shoots up to $ 18. The buyer exercises the option and makes a profit of $3 per share. However, if the stock remains below $15, the buyer doesnt exercise the right to buy and the writer earns the premium paid by the buyer at the time of writing the option.

Inherent Safety in the Covered Call Writing Process

Covered call essentially means first owning a particular stock and then selling it (or writing it off). In the options trading, its a common practice to sell the stock without actually first owning it. However, in case of a covered call, the stock to be transacted is first owned and then sold (written off) by the securities trader. Covered calls are considered safer because they diminish the risk borne by the writer, as the stock does not need to be bought at the market price, if the holder of that option decides to exercise it. A particular thing to note about the covered calls is that in this case, the risk of ownership of the securities is not eliminated.

Covered calls are safer because the writer (seller) already owns the stock against which the option has been written off. In case the buyer of the options contract decides to exercise his right to purchase the securities, then the writer need not purchase them at the prevailing market price which may be higher than the price at the time of writing the options contract. Hence, the writer eliminates the risk of purchasing the stock at a higher market price prevailing at the time by bearing the risk of ownership of the securities.

Valuation of a Covered Call Option Contract

The value of an option is nothing but the premium that is paid to enter into the option contract. The option premium can also be called the price of an option. The buyer pays this to the seller (writer) of the option. Now that we have understood that options are valued based on their premium, let us analyze the factors that determine the premium of an option contract. The factors that bear an influence on the premium of an option contract are in turn responsible for the valuation of that option.

The three primary factors that determine the premium on an option contract are:

Intrinsic value of the underlying security Intrinsic value of an underlying security is defined as a difference between the prevailing market price of a security and the strike price of a security as mentioned in the option contract. As the prevailing market price keeps on changing, intrinsic value of the security also keeps on changing. The higher is a difference between the market price and the strike price, the higher is the resultant intrinsic value of underlying stock and the higher is the option premium.

Time value of the option contract The time value of an option contract refers to a difference between the current date and the expiration date of the option contract. This time provides a window of opportunity for the market price of an underlying security to move in a favorable position. The longer this time window of opportunity is, the higher is the premium commanded by the option contract. The length of this duration is directly proportional to the time value of the option contract. The premium of an option is also directly proportional to the time value of the option contract. The higher the time value, the higher is the premium.

Volatility of the underlying security The more volatile an underlying security in an option contract is, the higher are the chances of fluctuations in its market price, which in turn increase the instances of making a profit from fluctuations in the security. Hence, the higher the volatility in the underlying security in an option contract, higher is the premium paid on its option contract.

Understanding Time Value Decay in Covered Call Writing

Options contracts possess a unique characteristic. They carry an expiry date after which they are rendered useless i.e. they cannot be traded anymore. Since an options contract is a function of time, it is essentially a decaying asset. It loses its value as the time passes by. Time is always against the option buyer and in favor of the option writer (seller). If a person holds an option contract, the market should move in his favor before the arrival of the option contracts expiry date. If the price remains below the option contracts exercise price, the option contract expires worthless.

An option is said to be at the money, when the option contract has a strike price, which equals the current price of underlying stock/commodity. If the price of a commodity/stock is equal to the strike/exercise price, it is said to have a zero intrinsic value, however, in such a situation, it also has the highest time value as compared to the value of other option exercise prices for same month.

The time value decay of an option contract can be defined as a ratio of change in price to a decrease in the time to its expiration. While approaching the expiry date and trading below the exercise price, the time value of an option declines as the probability of the option getting profitable (in the money) keeps on reducing. This is also called as theta or the time-value decay.

The time value decay of the option contract accelerates as the expiry date approaches provided that the option is trading below the exercise price.

Let us take an example:

Suppose a person X holds a call option in crude.

Crude is currently trading at $65 per barrel

X currently holding a crude call option with an exercise price of $70 and which will expire in a month.

As the month passes by, the probability of the price of crude going above $70 a barrel keeps on decreasing and this phenomenon is referred to as the time value decay of the option. As and when the window of time closes on an options contract, its time value decays. The time value in an option contract works in favor of the option writer (seller) and against the option buyer. The time value decay of an option has to be discounted by both the parties at the time of entering the contract. This is also the reason why the price of an option contract falls sharply as the expiry date nears. Since option contracts are loaded in favor of the sellers due to the time value decay, the buyers should ensure that they:

Buy options with longer time to expiry

Prefer options when the market volatility is low

Match buying options with selling options

Keep profit targets in mind while buying options

Buy options whose exercise price is close to market price

Writing In-the-Money Covered Calls

Why write In-the-Money covered calls? The answer is very obvious. However, to comprehend the underlying logic, we must first understand the concept of In-the-Money covered calls. The term tells us how far the strike price is from the current market price of the financial instrument. If the market price is higher than the strike price, the option is referred to as In-the-Money. In other words, we can say that if an option has an intrinsic value that can be converted into hard cash due to favorable market conditions; it is termed as In-the-Money. Even for stocks that are In-the-Money, the higher the intrinsic value, the higher is the premium paid to the option writer. Therefore, the intrinsic value and the premium are directly proportional to each other.

Writing In-the-Money covered calls makes sense because it can yield significantly higher premiums to the option writer. In case of a covered call, the option writer already holds the underlying stocks. If the option has a higher intrinsic value, the contract can be sold at a decent price compared to the situation where the intrinsic value is low or doesnt exist at all. The logic is similar to selling something when its utility as well as the price commanded is higher. The decision to sell In-the-Money covered calls becomes all the more significant when we discount the time-value of an option. Every option has an inherent time value that decays with time and reduces to zero when the option expires. The time value also has an effect on the premium. The effort should be to sell an option as far away from its expiration date as possible.

When the effects of both In-the-Money (intrinsic value) and the time value are taken into consideration, we can clearly understand why due emphasis is being paid on writing In-the-Money covered calls. By exercising this option, an option writer can profit from the intrinsic value together with the time value, which has a multiplier effect in pushing up the premium of the option contract.

Writing Out-of-the-Money Covered Calls

When the markets fall, one who makes the earliest exit gains the most. The same principle applies to writing Out-of-the-Money covered calls. When a covered call is Out-of-the-Money, it clearly implies that it has got no intrinsic value. The option writer then has to make a decision. It is whether to sell it or hold on. Holding the option and waiting for the intrinsic value to rise might seem logical but it certainly entails losing out on the time value component of the option premium. On the other hand, by selling the option, the writer can extract the maximum time value but has to contend with the absence of intrinsic value in the option contract. This situation poses a dilemma. The option writer has to choose between the time value and the intrinsic value of the option. He has to analyze the impact of each component on the premium and then take a logical decision based on facts.

Intrinsic value The intrinsic value of an option is the difference between the current market price and the strike price of the stock in the option contract. The more the difference, the greater is the intrinsic value and the higher is the option premium.

Time value The difference between the present date and the date of expiry of the option contract is called the time value of an option. The more the difference, the greater is the time value and the higher is the option premium. The time value of an option reduces to zero on the expiration date.

The option writer has to carefully analyze the impact of both the intrinsic value and the time value on the selling price of the option. On careful analysis, it is observed that the intrinsic value of an option has a linear relationship with the premium commanded by the option contract. The premium varies in direct proportion to the intrinsic value inherent in the option. On the other hand, time value of an option follows an exponential curve. The rate of decay of time value of an option increases as the expiration date approaches. Therefore, as the date of expiry approaches, the rate of decay in the time value also accelerates and starts to have an increasing impact on the selling price of the option.

Based on the results of the above comparison, it is not difficult to deduce that as the expiration date of an option approaches, any gain in the intrinsic value is more than offset by the corresponding loss in the time value of the option. The net effect of both these forces is that the selling price of the option declines more rapidly than its rise. This is the underlying reason why option writers write Out-of-the-Money covered calls.

Writing Covered Calls When Earnings are Due

When the earnings on an underlying security are due, this information is discounted in the option premium and it goes up. The seasoned option writers commonly use this technique to jack up the prices of their call options. The knowledge of the due earnings of an underlying security pushes the option premiums up to a certain level that is consistent with the option returns by taking the security earnings into consideration. Therefore it is always desirable for the option writers to write their covered calls when the earnings on the underlying securities are due or fall within or on the maturity period of the covered call option. When the market discounts the news of the due earnings, the option premiums are automatically headed north. This ensures that the option writers get a better deal.

The option writers stand to gain by the news of due earnings on the underlying securities in terms of better strike prices and favorable maturity periods. The news of the security earnings provides a kind of leverage to the option writers. Moreover, the option buyers are also willing to pay higher premiums when they become familiar with the news of due earnings on the underlying security in an option contract. When the news of earnings reaches the public domain, the market price of the security also aligns itself to reflect the news.

Writing covered calls when the earnings are due has twin advantages for the option writers:

The option writers manage to get higher premiums on their covered call options. This is due to the fact that the option buyers discount the news of the due earnings.

The intrinsic value of the underlying security goes up when the news reaches the public domain and is discounted in the market price of the underlying security. This helps the option writer if he is thinking of rolling his position on the option and earning the price differential or the spread of the two option contracts. This way, if the option writer decides to retain the underlying stock, he can maximize his returns by selling the stock at the increased market price.

Thus we can conclude that writing covered calls when the earnings are due is a great strategy for the option writers since they stand to gain both ways: when the option buyer exercises his option and when they decide to roll their position and keep the stock with themselves. In the former case, it is the appreciation in the premium amount while in the latter case; it is the higher market price of the underlying security that works for the option writer.

Expected Returns on a Covered Call

Since covered calls are market-traded products, its performance is closely linked to the market performance. In order to be able to correctly predict the covered call writing returns, one need to be able to correctly predict the overall market returns. Both are tough indeed, if not outright impossible to achieve. Having said this, one thing is for sure. The covered call returns and the market returns fall in close vicinity to each other. Give and take a few percentage points, both the financial instruments provide mutually proximate rates of return to the market participant.

The only difference between the markets and the covered calls is that covered calls manage to give returns even when the markets are on a downward spiral by way of the option premiums. Covered calls give superior returns when the markets are sluggish. However, a trader cannot be at a loss by trading in both the market indices as well as writing covered calls because either of the two is bound to compensate for the non-performance of the other. Both these instruments cannot fail an investor simultaneously.

Maximizing Covered Call Returns

Covered call options are financial derivatives that inherently require a proactive approach from the investors, more so in a bull run. These options require the market participants to squeeze out as much returns as they can by taking favorable positions in an upward swinging market. It allows the investors to take charge when the markets are favorable and stay calm when they are moving in the unfavorable direction. This implies that the investor gets an opportunity to make money both ways and more so when the market currents are easy on him.

There are three common ways of booking profits from the covered call options. The three ways are discussed below:

Option premium This is the most common form of returns given by the covered calls. The option buyer pays the premium to the call writer. The premium can be thought of as the cost of keeping the option of buying the underlying stocks at predetermined prices. The option writer earns through this mode when the option is out-of-the-money and the buyer doesnt exercise his right and let it go. This is how options generate returns during adverse market sentiment.

Exercising the option If the market price of a security appreciates and goes above the strike price in the option contract, the option is said to be in-the-money. Such options have a high intrinsic value that is the differential between these two. This is the common way of profit booking by the option buyer and is exercised when the underlying securities appreciate in market value.

Rolling/Flipping the position The option writer takes this route if he wants to keep the underlying stock. The option writer buys another option and sells the previous one. The difference between the prices of the two is called his spread and he gets to keep the stock with him. To flip the position, the option writer has to buy another option on the same stock and with the same maturity period.

Due to the reason that covered call option allows the investors to book profits in a number of different ways, it requires a careful understanding to ensure that they generate maximum returns by exercising those options. Two investors holding the same options for the same durations can end up having different returns because of the different approach taken by each of them. The role of the investor in extracting the maximum returns out of a covered call option cannot be overemphasized. To extract the maximum returns out of a covered call, the investors need to have a proactive approach. Covered calls as a financial instrument let the investors take charge and decide their own strategy.

Using Stop Loss in Covered Calls

A covered call stop order is a modification of the covered call option contract that is designed for the sole purpose of mitigating the losses of the involved parties. A plain vanilla stop order, when used in conjunction with a covered call makes a covered call stop order. However, the purpose of using the stop order together with a covered call remains the same, which is to mitigate the losses of the participants. The covered call stop order limits the losses and therefore acts as a safety wall in case of an undesirable market movement. The covered call stop order has a provision wherein it is cushioned against any sharp or unexpected market movement that could result in losses to the contractual parties. It is the usual stop order arrangement applied in the context of covered call options.

The stop loss, as the name suggests, is a technique of putting a limit on the quantum of losses in an individual trading session. Persons who transact heavily on the stock exchange frequently use stop loss to put a tab on their losses in one go. Those people are known as day traders and they are different from the investors in terms of the number of transactions, which they undertake. The day traders dont purchase shares to invest but rather to trade. Their time horizon is very short and they focus mainly on maximizing their day-to-day trading profits. The day traders deal in volumes because the average daily margins from stock trading are quite thin in comparison to those generated by long-term investments. Long-term investors dont bother about the short-term volatility in the market and therefore seldom take advantage of stop loss orders.

Entering a covered call stop order is a simple two-step process that can be easily performed on the trading terminal provided by the brokerage houses to their customers:

The first step involves taking a covered call. The trader decides which positions he wants to take depending on the prevailing market sentiment.

After the choosing to write a covered call, the trader evaluates the underlying stock volatility and decides whether or not to place a stop loss order for his position. If the stock volatility is found to be relatively high, the trader places a stop loss order with the brokerage house so as to minimize the exposure to unfavorable market situations. The placing of a stop loss order with the brokerage firm concludes the second step.

Most of the brokerage houses accept stop-loss orders for free or at a nominal cost to the customer. However, as a trader, the price is never too high to pay considering the amount of protection this simple measure can provide in case of a market fall. Thus, we can see that a covered call stop order combines the advantages of a stop order and the flexibility of a covered call option. It is an attempt at getting the best of both the worlds.

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