A Covered Call option strategy is also known as the buy-write strategy. It is carried out by selling a call option and at the same time owning an equivalent number of shares in a portfolio of the underlying stock.
Covered Call is considered a conservative strategy because it reduces the risk of holding the shares while providing an additional income. However, if the price rises significantly, our potential reward to the upside gets capped.
Before really evaluating Covered Call let us first properly understand a call option and its basic workings. A call option is a contract where the purchaser of the option gets the benefit from a rise in the stock price (and premium) over a limited period of time. There are several strike prices of a call option among which a purchaser can pick of the underlying stock. The purchaser can only make a profit when the stock price rises above the strike price and the purchaser can exercise his option. Conversely, if the stock price falls below the strike price at expiration, then the option will become worthless. The volatility of an underlying stock decides the price of an option.
The Covered Call option is an excellent strategy for investors and traders. It allows the portfolio to generate profits by collecting premiums on written call option in addition to dividends received from the underlying stock. Historically, this strategy has provided healthy returns to investors with a significantly lower risk level.
The Covered Call strategy is designed in a way that not only provides equity exposure but along with it ensures an attractive sustained yield. The Covered Call is made for investors who desire a high level of income as well as capital gains.
Mechanism of Covered Call
When we sell an out of the money call option, it caps the return of the portfolio at the strike price until the option expires. The option has monthly expiry, which can be extended up to three months. To illustrate this scenario let’s take an example. Consider a portfolio that has 100 shares of IBM at a current price of $70, which means the value is $7000. At the Money (ATM) call options (strike price of $70) which would expire in a month are valued at a premium of $1.5 per contract. A Covered Call is implemented by selling call options with a size of 100 shares for which we receive a premium of $150.
Payoff without exercise: Stock price at the call strike price
If the stock price remains at $70, the calls will go unexercised, and the portfolio benefits from the premium received. The new portfolio value is $7,150.
Break-even point: (Stock price – premium received)
If the stock price drops to $68.5, the calls are not exercised but the portfolio holding value drops. The new portfolio value is $6,850+$150=$7000, which is the break-even point. The portfolio goes into loss at any price below $68.5.
Payoff with exercise: Stock price above the call strike price
If the stock price rises to $72, the calls are exercised at $70, which nullifies any benefit gained from rising stock price, and we will be left out with only the premium received. The new portfolio value is $7,150.
Here is a graph which illustrates the payoff characteristics:
Impact of market conditions
There are certain states of the market for which the covered call strategy suits the best. They outperform in a flat or down market and underperform in periods of rapid price appreciation.
The Covered Call strategy gives the best results when the underlying stocks are range-bound, which means the stock price needs to be not very volatile. The strategy still works in the modest stock appreciation above the strike price with the added benefit of the sold call premium.
When the stock price advances higher than the strike price by a lot, then the call option will move into the money. Hence for the call writer, the gains are capped to the premium received.
The strategy also is not suitable in case of significant price drops. In this case, the strategy provides limited protection when the stock price declines. There is an overall reduction of the stock portfolio, which is only partially compensated by the premium received.
In choppy markets, the covered call strategy tries to give the stock portfolio exposure to reduced volatility. The strategy may outperform or underperform depending on how wild the moves are.
The choice of the strike price will depend much on the implied volatility of the stock option and general economic conditions. We choose a strike further Out of The Money (OTM) when volatility is high and closer to the money when volatility drops. The premium increases when volatility rises. In this way, we can choose faraway Out of The Money (OTM) options and still get the desired level of call premiums. This dynamic selection allows the Covered Call to have greater participation in volatile markets. Conversely, if the volatility is low, then we need to look for options that are near the current market price. Because there is less potential for short term price appreciation.
The optimal choice of option would be to select an option with 1-2 months to expiry to get the maximum advantage of time decay. Options lose more and more of their value as they get closer to expiry. Options are generally held until expiry.
Hence it is recommended to first try the strategy on a demo basis to properly understand its functioning. Later can be applied to a real account once you become experienced. All the best.