Understanding Covered Calls
If you want to get started in options, then you have to start somewhere so why not start at the place that the experts consider the most conservative options trade out there, the covered call. It is so considered so conservative that it is often allowed in retirement accounts. It is allowed in mine, and I use it extensively even though I would disagree with its conservative nature, but that is the topic for another post. Instead, I want to explain what the covered call is and explain the process of writing or selling a covered call.
Breaking Down the Terms
First, we need to understand the terminology and that means knowing what a call options is. Simply stated, a call option is a contract that allows the owner of the call the right (but not necessarily the obligation) of buying a particular underlying stock from the call seller at the strike price on or before the expiration date. If none of that made any sense, you may want to check out my two posts “What is an Option?” and “Components of an Options Contract” for a more detailed explanation.
The next term is the word covered. Covered means the same thing when you go out with a buddy and offer to buy his dinner. Saying, “I’ve got it covered” means you have the cash to pay for it. Having the call covered means that you have the stock to live up to the obligation that selling a call places upon you. If I sell a covered call on Intel stock, that means I have enough shares of Intel stock in my brokerage account that moment for fulfilling my obligation if that stock gets called away from me.
The alternative to being covered is being naked. A naked call is one that is sold without owning the stock or enough of the stock to meet the call obligation. If the call gets exercised, then the seller of a naked call would have to go into the open stock market and purchase the shares for delivery to the owner/purchaser of the call.
Writing a Covered Call
So if we are writing a covered call, we are selling call options against stock that we already own in our brokerage account. This is why it is considered a conservative investment strategy. The stock is already owned so the risk of having to go into the open market and buying the stock (as would occur with a naked call) no longer exists.
The process of writing a covered call is simple. The first step is to own an optionable stock. Not all stocks will allow options contracts to be written against them, but the stocks of the larger companies will. This is determined by the Chicago Board of Options Exchange. Assuming you own such a stock, then for each 100 shares, 1 option contract can be written. This is a very important point and can get a little confusing at first. Again, a round lot of stock is 100 shares and each call option is for 100 shares of a particular stock.
Another term you will run across is open interest. A contract doesn’t exist until someone actually opens one and offers it for sale in the market. You can see the amount of open interest along with the pricing quotes in the option chain which is a list of strike prices, expiration dates, and bid/ask prices for a particular option series in a given stock. Typically, the most open interest occurs around the current market price of the stock.
In order to sell (or write) a covered call, one would go to the proper options trading page in one’s brokerage account and enter a “sell to open” order for a particular call option which would specify the number of contracts, the underlying security, expiration date, and strike price. The next step is to enter a market order, meaning the option would trade at the market price (not wise) or a limit order, meaning that you set the price you are willing to accept. Typically there is also a criterion for the order such as “good til canceled” or “day order”. And that’s it, you have written a covered call.
An Example is in Order
Of course, it is always easiest to learn by example so let’s look at one together and explain as we go.
Investor Warren has a portfolio full of stock and would like to begin selling covered calls against that stock. He owns:
- 2,000 shares of Coca-Cola (KO) and
- 1,000 shares of Bank of America (BAC)
He decides to write calls against half of his positions in order to gain a little more income for the portfolio. Starting with KO, he sees that the stock is trading at $69.57 per share. He would be willing to part with the stock in the next 3-4 months for $75 per share so he looks at the January 2012 call chain and finds that the bid is $1.14 per share for the $75 strike price. He goes into his brokerage account and enters a limit order to sell 10 call contracts for $1.15 for the day only. Within an hour, the stock has traded up to $69.80 and his limit order is filled.
Now what has he done? He has agreed to sell another investor 1,000 shares (remember each contract is for 100 shares) of Coca-Cola stock for $75 per share any time between now and the third Saturday of January 2012. If KO is at $100 on January 21st, then the call buyer made quite a profit. If KO is still at $70, then Warren will keep his stock and the option premium that he received. He also would have realized an additional 1.5% yield on his stock.
Doing the same with BAC, he finds that he can sell call options with the $7.50 strike price expiring on January 21, 2012 expiration for $0.63 and is happy with that so enters a limit order to sell 5 call contracts. These sell and Warren is happy when BAC is trading at $8 on that day because he made the 63 cents per share option premium and an additional $1.02 in capital gains from the current $6.48 stock price for a total profit of $1.65 on his $6.48 investment or a gain of just over 25% in less than 4 months.
I hope that you better understand the process of writing a covered call and have a better sense regarding what is involved. Next week I will offer some tips for being more successful writing covered calls. In other words, I will share what I have learned from all my mistakes.
Readers: Did you understand what I wrote? Have you written any covered calls? Do you think this might be something you would like to try? Feel free to comment below.