It is sort of unusual for me to write about a topic like covered call options. It is something that will come up in a future post about split shares I am drafting right now, and it is kind of a heavy topic so I thought I would give it a post all on its own instead of cramming it into a future post. I also find it a extremely interesting topic, even though I will most likely never take part in any options trading myself.
A book I read recently called “A Mathematician Plays the Stock Market” has a pretty good description of covered call options. But before understanding what a covered call option is, one has to understand what a call option is. A call option is a right to buy a stock (but not obligation) at a certain price (the strike price) within a specified amount of time. For example, stock options offered by companies to employees are call options (as opposed to put options). Although “stock options” involve the issuing of new stock whereas with call options, the shares are simply being transferred from one owner to another.
You can also sell a call to someone, ie. sell someone the right to buy shares in a company at a certain price within a specified time period. If the stock doesn’t move above the strike price, you keep the proceeds from the sale of the call option. If the price of the stock moves above the strike price and the buyer of the call option exercises their option, you have to buy some shares at the current market price and provide them to the buyer at the strike price. Essentially you are buying them at the current price (a high price) and selling them to someone else at the strike price (a low price). So selling calls is a bet that the stock price will decrease.
Another strategy is to buy shares and simultaneously sell calls on them (selling “covered” calls). You could for example, buy shares of ABC Corporation at $25 and sell 6-month calls on them with a strike price of $30. If the stock price doesn’t rise to $30 you keep the proceeds of the sale of the calls. If the stock does rise past the strike price of $30 to $35, and the buyer of the call exercises their option, you can sell your own shares to the buyer of the calls. Selling “covered” calls (calls in stock you own) is safer than selling calls because you don’t have to buy stock in that company at a high price ($35). You already own stock in that company which you bought at a low price ($25) and can sell it to the buyer of the calls for $30. You make money on the stock’s rise from $25 to $30 as well as the proceeds from the sale of the call option and the buyer of the call option makes money from the stock’s rise from $30 to $35 minus the purchase of the call.
Here’s an example from the Wikipedia article on call options:
- An investor buys a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price) and an exercise date of June 1, 2006, and pays a premium of $5 for this call option. The current price is $40.
- Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.
- If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.
- Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100).
- From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller’s profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.
There is another example of selling covered calls at investopedia.org and another explanation here.
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