Most seasoned investors employ specialized options trading strategies to minimize their risk and limit their losses. One such options strategy that veteran traders and investors use on a day to day basis is the covered call. If you’re wondering what this is, here’s everything that you should know about the covered call option strategy.
What is a covered call?
The covered call strategy essentially involves an investor selling a call option contract of the stock that he currently owns. By selling a call option, the investor essentially locks in the price of the asset, thereby enabling him to enjoy a short-term profit. Apart from this, the investor also gets a slight protection from any future declines in stock prices.
When should you use the covered call option strategy?
The covered call is ideal for neutral and moderately bullish situations, where the future upside potential of the stock that you own is limited. This strategy is ideal when the outlook for the stock that you own is not very bright and when booking short-term profits would be a better idea than to keep holding the stock.
How does the covered call strategy work?
For utilizing a covered call option strategy, you’re required to first own the stock of a company. So, let’s assume that you already hold the stock of a company i.e. going long. Your view when you bought the stock was bullish, but as time passed, you’re now unsure of the future upside potential for the stock and so you don’t expect the price to rise much.
Under such a situation, what do you do? You can book a short-term profit and protect yourself from minor downsides in the price of the stock by using the call option contract of the stock. And so, you sell a call option contract of the stock at a strike price that’s higher than the purchase price of the stock. The buyer of the call option would in turn give you a premium, which you’re obligated to keep whether the option is exercised or not.
Now, here’s where things get exciting. After you execute a covered call strategy, one of three scenarios is likely to happen. Let’s take a look at them one after the other.
Scenario 1: The price of the stock rises H3
In such a situation, since you’ve effectively locked in the sale price of the stock by selling a call option, you get to enjoy a guaranteed short-term profit. In addition to this, you also get to pocket the premium that the buyer of the call option paid you. Therefore, it is a win-win situation.
Scenario 2: The price of the stock falls H3
In this scenario, you get limited protection from the downside thanks to the premium that you were able to pocket by selling the call option. This premium amount that you received can be used to reduce the impact of the loss that you had to suffer as a result of the fall in the stock price.
Scenario 3: The price of the stock remains the same H3
When the price of the stock remains neutral without any changes whatsoever, your profit would actually be the amount of premium that you were able to pocket by selling the call option contract of the stock. This is the case irrespective of whether the option is exercised by the buyer or not. Sometimes, the buyer might not want to exercise the option, in which case you get to enjoy the premium as well as hold onto your shares.
How to Use LEAPS in a Covered Call Write
A covered call strategy known as the “surrogate covered call write” offers the possibility for enhanced overall performance by substituting long-term equity anticipation securities for stock as the underlying asset.
To illustrate this surrogate technique, consider a hypothetical covered call written on J.P. Morgan (JPM) stock. Assume that the JPMorgan Chase stock is trading at 35.72. If an investor is somewhat positive on JPM, they can use a classic covered call, which offers some minor upside potential.
If the investor wishes to hold a six-month covered call, he or she may sell the slightly out-of-the-money 37.50 call, which is currently trading at $1.60. If JPM closed at the strike price of the 37.50 call (the maximum profit point) at expiration, the profit would be $1.78 per share plus the entire $1.60 profit on the call option sold but which expired worthless. Thus, the maximum profit per share is $3.38. Additionally, there may be a minor gain from any dividends collected during this six-month period that is not included in this calculation.
Now, instead of purchasing JPM shares, the investor might acquire a deep-in-the-money LEAP call option with a strike price of 25 and a maturity date of twenty-four months, which is currently selling at $10.70 in our case. In other words, rather than owning J.P. Morgan stock, a two-year call option LEAP serves as a “surrogate” for actual ownership of the underlying.
In an ideal world, this technique would work in an established bull market, which is typically characterised by low implied volatility. We seek a low volatility environment because LEAPs have a high vega, or a higher price sensitivity to volatility swings. Otherwise, LEAPs follow the same basic pricing principles and parameters as standard stock options.
Due to the option’s deep in the money status, the LEAP premium represents solely intrinsic value (i.e. very little temporal value). Due to the short duration of this option, it will have a delta near to 1.00. Thus, owning the LEAP functions as a proxy for owning the actual shares, but requires significantly less capital.
The owner of the LEAP can now sell the same JPM 37.5 call for $1.60 in exchange for this LEAP. If JPM closes at $37.5, the maximum profit is $3.38, the same as the prior example but with less upfront cash. As a result, the rate of return on capital employed is higher (ROCE).
Maximum Risk Mitigation
Assume that JPM closes at 30 instead of the maximum profit point anticipated above at the expiration of the options. As you can see, the standard covered call writing strategy results in a loss of $572 on the stock position ([$35.72 – $30] x 100 shares = $572). This loss is somewhat offset by the profit on the worthless July call, resulting in a net loss of $412 ($572 – $160 = $412).
The position would reflect the same loss amount for the LEAP-covered write. This assumes the LEAP maintains a delta score of 1.00, emulating the long stock position precisely. With a strike price of 25, the LEAP call is still firmly in the money at 30. As a result, it would have lost $412 ($572 – $160 = $412). However, if the stock price falls, the LEAP approach gains an edge.
For instance, if JPM closes at 25 at expiration, the loss on the standard write would be $500 greater at $912, whereas the LEAP-covered write can lose no more than $10.70 minus $160, or $910. Notably, the LEAP method might potentially result in a reduced loss at 25 if this scenario did not occur at the LEAP’s expiration. That would imply that there was still some time value remaining. If the LEAP retained its $1.50 time value, the $150.00 remaining premium would mitigate the projected loss.
Advantage of Volatility
When volatility is considered, the LEAP method becomes even more appealing. Due to the high vega of LEAPs, an increase in volatility would result in an increase in extrinsic (i.e. time value) value on a long LEAP position.
If interest rates rise, the position’s maximum loss would be further reduced, as call LEAPs appreciate in value as rates climb. However, dividends would have to be incorporated into the typical covered write, lowering the maximum loss.
One of the advantages of the covered call is the fact that you don’t have to time the purchase of your stock and the sale of the call option contract. You can sell the call option anytime after you’ve purchased the stock. That said, it is a good idea to always exercise a bit of caution when dealing with options and options strategies due to the amount of risk involved.