Generating short-term income using covered-calls
A widely adopted strategy by investors looking for short-term income is to write covered calls. Investors adopting a covered call strategy write calls while holding a long position in the stock. If you think that over the long run the stock price will continue to appreciate because it has strong fundamentals but that in the short run the price will depreciate, then by writing (selling) covered call options you can benefit from both scenarios.
Recall that options, as explained in our introductory article on stock options, is a contract between two parties that gives the option holder the right to buy or sell the underlying security from/to the option writer (the option seller) at a specified price (strike price) and within a defined timeframe.
Whereas the option holder is not obliged to exercise the option, the option seller is obliged to sell the stock shares (each option contract refers to 100 shares) at the given price if the buyer exercises the option. Because of the risk associated with such obligation, the option buyer pays a premium to the option seller. If the seller of the call option already owns the shares of the underlying stock he/she is writing a covered call. On the other hand, if the option writer does not already own the shares of the stock, it is known as a naked call which is very risky.
In order to have a better understanding of how writing covered calls work, let’s go through an example.
Writing covered calls example
Two years ago John purchased 100 shares of Company A for $5k ($50 per share). The stock is now trading at $75 per share and although John wants to continue to own the stock for the long term, he thinks that the share price will drop over the next month and decides to place a market order to sell one $79 March call option. The bid price for such call option is $5.00 (recall that when you insert market orders, as a seller you receive the bid price. Check out our post on how to read stock quotes for further information) so John receives $500 (because the bid price refers to 1 share and each option contract is of 100 shares). At the same time, Karen thinks that the share price of Company A is undervalued and that it will go up over the next month. As such, she decides to insert a market order to buy the same call option. The ask price for the same call option is $5.20 so she pays $520. The difference between the ask price and the bid price is known as the spread and it goes to the market maker.
In the following scenario, Karen wants the share price to go above $79, while John wants the share price to stay below $79. If the share price remains at or below $79 until the call option expiration date (third Friday of March), the option expires worthless and Karen loses $520 while John makes a $500 profit. If instead the share price goes above $79, Karen would exercise the call option and John would be obliged to sell the 100 shares for $7900. Whether or not the option holder decides to exercise the option, the option seller keeps the premium.
Writing covered call outcomes
As you can see from the above example, writing covered calls can be a very profitable income-generating strategy. If the share price appreciates (above the strike price) you sell the shares for a capital gain. If the share price remains the same until the expiration date you profit from the premium, and if the share price drops below the strike price, the premium helps offset the loss. As a covered call option writer, you want the share price to stay just below the strike price, so that your potential gain in greater. If the share price drops significantly below the strike price, although you still get to keep the premium paid by the option buyer, it will not outweigh the loss of value of the shares (recall that if you are using such strategy it is because you still want to keep a long position in the stock).