Covered Calls Strategy. What Is Calls Writing?

Writing covered calls is a widely used options strategy. It involves entering a contract to sell or buy an asset at a predetermined price on or before a specified future date. When you simultaneously purchase shares and write calls on them, the transaction is known as a buy-write. If you write calls on shares you already own, it is referred to as an overwrite.

This strategy blends the advantages of owning stock with options trading, providing mutual risk protection. By writing covered calls, you retain shareholder rights, such as receiving dividends and voting on company matters.

Covered calls offer an opportunity to earn additional income from stocks you own and provide limited downside protection by locking in a price at which you can sell your stock if the option is exercised. However, if the stock’s price rises significantly, your call option may be exercised, and you may have to sell your shares at the strike price, potentially missing out on further gains above that price.

What is a Covered Call Strategy?

The covered call strategy involves selling call options while owning the underlying shares. By writing calls against shares you already own or have recently purchased, you can generate additional income. The term “covered” refers to the fact that you possess the necessary number of shares to fulfill the option contract.

With the covered call strategy, you can benefit from the income generated by selling call options while retaining the advantages of stock ownership, including dividends and voting rights. However, if the call option is exercised, you will need to sell your shares, which means you might miss out on potential further gains.

By using the covered call strategy, the investor sacrifices the opportunity to fully capitalize on a substantial increase in the underlying asset’s price in exchange for the premium received. As a result, the profit potential is capped. This strategy is most suitable for investors who believe that the underlying asset’s price is unlikely to experience significant fluctuations in the near term.

Why use a covered call?

Writing calls can be a strategy to generate short-term income from the premiums you receive. If your expectation is that the option will expire out-of-the-money and go unexercised, you retain the entire premium as profit. When writing a covered call—where the call is written on stocks you already own—the premium can effectively serve as a virtual dividend on those assets. This approach is often used by investors to earn additional income, especially on non-dividend-paying stocks. Additionally, the premium can be seen as a way to reduce your cost basis, effectively lowering the amount you paid for each share.

If you opt for this strategy, you’ll need to maintain the minimum cash margin requirement in your margin account to cover the potentially significant losses if the option is exercised. Moreover, if you are assigned, you must buy the underlying stock to deliver it and fulfill your obligation under the contract.

How to calculate covered call returns?

To calculate the return on a written call, you must factor in transaction costs and brokerage fees, which will be deducted from the premium you receive. Additionally, if your option is exercised, you’ll incur another round of fees. However, if your strategy is successful and the option expires unexercised, you’ll avoid any exit transaction fees or commissions.

If you write a call on stock held in a margin account, be sure to account for your firm’s margin requirements when calculating your return. Although you retain all your capital if the trade succeeds, it will be tied up in the margin account until expiration, limiting your ability to invest it elsewhere during that period.

It’s also important to consider the timing of dividend distributions when writing options. The likelihood of the option being exercised increases significantly right before a dividend payout. If the dividend date on a call you’ve written is approaching, it’s wise to re-evaluate your position and consider whether closing it out might be the best course of action.

What are calls exit and exercise?

If the stock or other equity on which you wrote a call begins to move in the opposite direction from what you anticipated, you can close out your position by buying a call in the same series as the one you sold. The premium you pay may be more or less than the premium you received, depending on the call’s intrinsic value and the time left until expiration, among other factors. You can also close out your position and then write new calls with a later expiration, a strategy known as rolling out.

If the call you wrote is exercised — as is possible at any point before expiration — you will have to deliver the underlying security to your brokerage firm. The assignment for an exercised call is made by OCC to any of its member brokerage firms. For example, suppose your brokerage firm receives an assignment on an options series on which you hold a short position. In that case, you may be selected to fulfill the contract terms if you were the first at your brokerage firm to open the position or by random selection, depending on the firm’s policy. It is extremely rare for the writer of an in-the-money call to not have to sell the underlying stock at expiration.

What are the pros and cons of the Covered Call Strategy?

A covered call is a common options strategy used to earn money through option premiums. In the covered call strategy, call options are written against a holding of the underlying security.
Investors may benefit in three different ways from covered calls:

• Investors might set a selling price for the stock that is higher than the current price by selling covered calls.
• It is possible to maintain the premium from selling a covered call as income.
• Investors can get some downside protection by selling covered calls.

The covered call strategy is not without risk:

• Investors set limits on the gains they may otherwise make from rising stock prices.
• They are required to keep holding the shares until the options expire.
• If the stock price falls below the breakeven point, money can be lost.
• Investors may be required to pay gain tax on covered call net gains.

Covered call strategies can be successful if you choose the right company to sell the option on and the appropriate strike price. Overall, covered call writing is appropriate for market situations that range from neutral to bullish.

Covered Calls Strategy. What Is Calls Writing? by Inna Rosputnia

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