Why You Should Use the Covered Call Strategy

“Calling the Trend” Column, by George Leong, B.Comm.

The current markets are largely trading in a cautious sideways manner. One way to profit in an uncertain market is with options. Within the world of options trading, the use of a covered call writing strategy has evolved into one of the most popular option strategies used by both institutions and the retail crowd. Why? Because the strategy is quite straightforward, low risk, and can generate premium income, while also locking in a selling price for a stock.

A straight call option is the most basic of option strategies. It gives the purchaser the right, but not the obligation, to acquire a specific number of the underlying instrument at a predetermined price (strike or exercise price) by a certain date (expiry month).

In the “writing a call,” the investor or writer sells the call option in the market in return for a premium (this is the income you receive for taking the risk). The writer then is obligated to deliver the underlying instrument at the predetermined exercise price if the buyer of the call option exercises the call. This would occur if the price of the stock rises above the strike price. Of course, everything must be done by the expiry date, otherwise, the option expires worthless and the writer keeps the premium. But if the writer wants to close out the options prior to a potential exercise, buying the same number of calls on the same instrument would do the trick.

To minimize risk, a call writing strategy should be “covered.” A covered call writing strategy entails the simultaneous buying of an underlying instrument and writing an equivalent number of call options on the underlying instrument. Alternatively, for those already holding a long position in an instrument, all you would have to do is to buy an equivalent number of call options.

Investors initiating a covered call writing strategy have either a bullish or neutral outlook on the underlying instrument.

There are three major reasons behind the use of covered calls as a trading strategy.

First and foremost, the writer reduces the risk of holding the underlying instrument. For example, if the stock declines in value, the writer would partially offset some of the paper loss in the stock by the premiums. In fact, the premium income is the second major reason for initiating this strategy. The third reason is that the writer could establish a predetermined price (the strike or exercise) at which he or she is willing to sell the stock. The disadvantage with this strategy is that the writer would have to relinquish the shares if exercised, which means missing out on any further gains.

In terms of the exercise month, the writer would want the shortest time to expiry, since it leaves little time for the stock to move above the strike price. Professional option writers generally look for calls with less than three months to expiry.

The maximum risk for the covered call writer is the cost of the underlying instrument less the premium received.

The maximum reward is the difference between the strike price and the initial purchase price of the stock, plus the premiums.

Because options are inherently risky, we recommend speaking with an options specialist before considering a strategy.