Options Trading Strategy: Covered Call Writing explained

In this post I will discuss two hedging strategies in futures and options trading: Covered Call and Covered Put. Some variations of the covered call and put strategy will also be discussed. If you are new to Stock Options trading and futures trading you might want to first read my posts on

If you are already familiar with derivatives, you may scroll down the introduction and see variations of covered call and covered put writing at the bottom table or post a comment.

What is a Covered Call Strategy?
Covered Call is a Options trading strategy in which you
  1. Buy the underlying , i.e. a stock, commodity or a Futures Contract.
  2. Sell or Write a out of the money Call option for the same underlying, i.e. write a call at a strike price slightly higher than the price of the underlying.
Understanding Covered Call by an example: Suppose the current price of a company, say Coca Cola, is $20 per share. You anticipate that the price of this share is going to go up so you buy a futures contract that will allow you to buy 100 shares of Coca Cola at $20 at the expiry date. But there is a risk- what is the price of this share does not rise? if the price drops you could be at a loss. In order to minimize this what you can do is the following - Sell a Call Option for Coca Cola at strike price of $21. Say you get a premium of $1 per share after writing this call option. This call option that you sell is called a covered call. Writing or selling a call option always has a risk - if the price rises beyond the (strike price+premium), in this case $22, of the option you have written you start making a loss. In principle you could make an unlimited loss while writing a call option. In this case even if the price rises, you will not make a loss because you have already bought a future. In other words the risk of call option writing is covered by your future. In the current example -
  • You gains or profit increase as the price of the stock rises until the strike price of the call option that you have sold, i.e. $21. Beyond $21 you do not make any additional profit because the gains in the futures contract are offset by the loss by the call option you have written. In other words the maximum profit that you will gain by writing the covered call in this case is equal to (strike price of the call option - futures price + call option premium)=$2 per share.
  • Even if the price of the stock drops by a small amount, say less than $1, you do not make a loss, in fact you end up making a profit because the options premium that you recieved by writing the covered call option. Thus a small downside of the future is 'covered' by the options premium.
  • You make the loss if the price of the stock drops below $19. The amount of loss you can make is not limited in the case of the covered call strategy. In principle you capital can be wiped out. Thus covered call option writing strategy is useful only when you anticipate an upward movement in the stock option price.
Some Jargon related to Covered Call
As explained above, writing an out of the money call option when you already own the underlying (in the form of physical stocks or a futures contract) is called as a covered call. If you simply write a call option without it being 'covered' by a futures contract or underlying which you already have, it is called writing a naked call option. The Break Even Point (BEP) of the transaction of writing a covered call is the price below which you start making a loss by selling the covered call. More precisely
Break Even Price = Price of the Underlying (or Futures) - Premium recieved by writing the call.

What are advantages of Covered Call options writing strategy?
All the benefits of covered call strategy are actually illustrated by the above example. Let me quickly relist them without explaination.
  • By writing a covered call - you make profit if the price rises.
  • Some portion of your loss is covered by the options premium that you get by selling the call option.
Note that Covered Call strategy is not necessarily a 'profit maximizing' strategy but in fact a hedging strategy, i.e. a strategy in which you try to minimize the risk. There is an obvious variation of the covered call strategy where instead of buying a 'futures contract you actually by the underlying if it is stock or a commodity. However this variation is not really a new options writing strategy. Here are some minor 'real variations' of covered call writing.

Some variations of the Covered Call Options Strategy
Futures Options Trading Strategy
Remarks
Covered Put Strategy
Sell a Futures Contract on a stock/index.
Write a Put Option on the same stock/index at a strike price below the price of the Futures contract.
Writing Covered put is suitable when you have reasons to believe the price of the underlying is going to go down.
Buy a Call, Write a Call Strategy
Exactly like the Covered Call strategy but where instead of buying a futures contract you buy a 'at the money' options contract and write a out of the money option.
An at the money option is certainly more expensive than an out of the money option. So in this strategy, unlike the 'pure' covered call, to start with you are at a loss and in order to make profit the price of the underlying MUST rise. However as opposed to covered call strategy there is limited 'downside loss'.
Covered Call + Buy a Put Option Strategy
You use the options premium obtained by selling the covered call to buy a out of the money put option.
This variation of the covered call strategy is suitable when you have strong reasons to believe that the price of the underlying will rise but also know that if something goes wrong then it will go wrong by a big margin, i.e. you dont want to take unlimited risk but you cover the downside risk of your futures contract by buying a put option.

Similarly the last two strategies mentioned above have an obvious analogue for the put option.

Options Greeks

  • Option Greeks for Beginners (with free Options Calculator)
  • Option Greek Delta and Delta Neutral Options Trading Strategy
  • Option Greek Theta and its role in Options Trading Strategies
  • Option Greek Vega and implied volatility
  • Option Greek Rho - does it really matter in your Options Trading Strategies?
  • Stock Market Derivatives: Futures, Options

  • From Forward contract to Futures.
  • Stock Futures example - Futures trading basics explained.
  • Stock Options trading examples - Call Option Example and Put Option example.
  • Covered Call and Covered Put - Simplest Options trading strategy.
  • Volatility and Options Pricing - How is Option premium priced?
  • Lot Size of a Derivatives Contract - Contract Unit

  • Options Trading Basics
    In the Money Stock Options
    At the Money Stock Options
    Out of the Money Stock Options

    Mar 22, 2009

    1 comments:

    Benjamin Lee April 20, 2009 at 4:25 PM  

    Writing covered call is a good options strategy to used in consolidation market.

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