There are times when a trader is certain prices will fall. At times like this, they can sell stocks they believe are overvalued and move to cash. But there could be valid reasons that make a trader reluctant to sell. For example, selling a position that has been held for years could create a large tax bill. While selling could avoid a loss the tax bill could be more than the amount that would be lost. Or the trader might believe that prices are likely to decline in the short term but believes the stock will deliver large gains in the long run. Rather than trying to time the market, they prefer to hold on to the stock rather than risk failing to buy the stock back in the future. This is a common problem. We sometimes see investors sell, intending to buy back in after a decline but instead they become paralyzed into inaction as prices fall, failing to buy because they expect more declines.
Fortunately, there are strategies that allow traders to benefit from short-term pullbacks or even large selloffs in stocks while they continue to hold the stock. Among these strategies is covered call selling.
Option trades, like trades in any other market, require both a buyer and seller in order to complete the transaction. The buyer of a call option is buying the right to buy a stock at a predetermined price for a specified amount of time. The buyer will only exercise this right if the price of the stock rises above the predetermined price in the option contract which is called the exercise price or the strike price. If the stock remains below the exercise price, the buyer would have no reason to exercise the option because it would be cheaper to buy the stock at the lower market price. In this case, the seller of the call option profits because they keep the premium the buyer paid for the option.
In the transaction, the option seller, or writer, is granting the call buyer that right to buy and the seller agrees to accept an obligation to deliver the stock if the price rises above the strike price. The option seller can buy the stock in the market to deliver it and accept the loss. Or, if the option writer already owns the stock they can deliver the shares they own. This is, in effect, just a sale of the stock.
If the call writer owns the stock when the call trade is opened, the call is said to be covered. That means the options writer has covered the position in the options contract with a long position in the underlying security.
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As an example, let’s assume a trader owns 100 shares of IBM (NYSE: IBM). Each option contract covers 100 shares so they could write one covered call contract against those shares. If IBM is trading at $150, they might write a call with a strike price of $175 expiring in one month. For the call, they earn $3 a share or $300 in total, before commissions. If the stock pays a dividend while the option is open, the writer keeps the dividend since the call trade has no impact on their shareholder rights.
If IBM rises above $175 before the option expires, the buyer could exercise the option and the shares would be sold from the option writer’s account at the strike price. In this case, the covered call writer would keep the $300 premium and would sell IBM at $175 for a profit. In total, the investor receives $178 for each share of IBM when the option premium is considered.
If IBM stays below $175 until the option expires, the buyer would not exercise their option. The call option would then expire worthless. The writer keeps the $300 and no action is required on their part. They still own 100 shares of IBM and they are free to write another option against those share or simply continue to own the stock.
With a covered call, the upside is limited while the option is open but the downside risks are mitigated.
Covered call writing is usually considered to be a low risk, income generating strategy. Traders who own a stock can sell deep out of the money calls to receive small premiums while they continue to benefit from appreciation in the underlying security. A deep out of the money call is one with a strike price well above the market price. For example, a strike price 20% or more above the current price of a stock could be deep out of the money for an option expiring in one month. The probability of a large move in the stock is relatively small and the premium earned for selling the call can add to the profits of the position.
If a trader expects a market selloff, they could sell calls with strike prices closer to the market price, perhaps 10% above the current price. Calls with strike prices near the market price will generally offer higher premiums than calls with strike prices further away from the market price.
It’s also possible to use a covered call strategy to sell a stock. This can result in a slightly higher price on the transaction if the call is overvalued relative to the stock price when the call is sold. If a trader with 100 shares of IBM wanted to sell at the market price and noticed there was an at the money call expiring that week selling for $3, they could sell the call and make an extra small profit on the trade when the call is exercised. These opportunities will not always be available but they are possible, especially in volatile markets. Volatility is one of the most important factors in determining options prices. When volatility is high, options are frequently overpriced.
Covered call writing is another example of the versatility of options. In general, this strategy works best when the market is moving sideways. In that case, the stock price is in a narrow range and the call is unlikely to be exercised. Covered call writing also provides income and offsets losses when a stock’s price declines. The premiums received are unlikely to completely offset the losses but in a bear market, the premiums received from call writing will be welcome by many investors who desire to limit the losses in their accounts.
In a bull market, in theory, this strategy can increase profits. In practice, the upside will be limited by the strike prices of the options written. Calls will often be exercised in a bull market and the strategy is likely to lag broad stock market averages in bull markets.
Covered call writing is also known as a “buy-write” strategy. The Chicago Board Options Exchange calculates an index for covered call strategies, the CBOE S&P 500 BuyWrite Index (ticker BXM). This index did fare slightly better than broad market indexes in the last two bear markets. In bull markets, performance suffers as calls are exercised when prices rise. Underperformance can amount to a third of the market’s gains, or more.
An ETF, PowerShares S&P 500 BuyWrite ETF (NYSE: PBP), is designed to track this index. Other ETFs and mutual funds tracking this strategy are also available. These funds could be suitable for investors who like the idea of decreasing risk in bear markets. Of course, covered call writing on individual stocks can offer the same benefits to traders as a buy-write fund.