Introduction
A covered call is an option strategy, in other words, it is a combination of an
position in an option and a position in the underlying stock. In essence, it
consists of a a long stock position, with one short call for each share. In this
node, building a covered call, the reason to do so, and the rewards and risks will be
discussed.
How to build a covered call position
First of all, one needs to have a position in a stock. It turns out that options,
unlike shares, cannot be traded in single units. Rather, each option has a
certain contract size. Normally, this is 100, although this should be checked
before the trade. So, if you buy one option contract with a listed price of of for
instance $2.50, you actually get 100 for $250. Ideally, the share position is
divisible by this lot size, so for instance 1200 shares.
The idea is now to sell a call on those shares. A call gives the right to buy the
shares at or before a certain time, and for a certain price. As the call is sold,
someone else the right to buy the shares from the seller. This is fine, as
the seller has those shares.
Which call to sell
On the other hand, if a short-dated call is sold, it is possible to sell more of
them, and this typically yields more than one long-dated call. Furthermore, a call
with a lower strike is sold, there is more chance it will be exercised,
and the seller is forced to sell the shares for less.
Option markets are typically quite efficient, apart perhaps for options with
strikes that are far from the current level of the share. As such, it is
mostly a matter of opinion which call to sell. Commonly, somewhat out-the-money
options (so with a strike that is above the current level of the share) are sold,
with a short time to expiry, often one month.
Rewards
The rewards are fairly obvious: we get the premium of the sold call. What this
means is that some of the upward potential of the shares is lost, which is
compensated by the profit from selling the call. This means that if the share
closes lower than the strike, the covered call outperforms the shares; else, it
does not.
Risks
The risk of this construction can be seen from two different perspectives. It could
be compared to the risk of a naked share position, or it could be compared to
having money in a bank earning the risk-free rate.
Compared to a naked share position, a covered call represents mostly an
opportunity loss. If the share rises above the strike, selling it was a bad thing.
This is especially salient if the share jumps because of a takeover; in this case,
selling the call was not a good thing. In any other scenario - including dropping
share prices - the covered call outperforms the naked shares. Note that should one
want to sell the shares, it is normally best to sell both the shares and buy
back the call at the same time, not to be left with the risk of the unhedged call.
Compared to the risk-free rate, this is a rather tricky position. One is exposed to
the potential drops in the share price. As such, this position is almost as
risky as a naked long position; almost, as the premium received cushions the first
lossea. Furthermore, there also is an exposure to dividend and interest. In
particular, in case of a dividend, it is possible the shares get exercised,
so the new owner receives the dividend. This becomes more likely for a larger
dividend. On the other hand, a share going ex-dividend drops in value, making
it less likely that the call is exercised after this point, so in principle, an
increase in dividend is good, and a decrease is bad. In general, doing a short-dated
covered call strategy around a dividend date is tricky.
In principle, a call increases in value if all thing being equal, the underlying
share becomes more volatile. This normally happens in a falling
market, and in that case, the call loses value because it is less likely to be
exercised. It is noted that if the covered call is kept until expiry, this exposure
to the volatility is subsumed by the actual value of the call, which is known at
exposure.
Conclusion
A covered call offers a way to use options to manipulate the risk profile of a long
shares position. In principle, it is a good strategy in a market that is
expected to be steady, neither rising nor falling too much. In case of a strongly
rising market, there is an opportunity loss; in case of a falling market, the long
shares cause a loss, albeit less than a naked long shares position.