Covered Calls Strategy. What Is Calls Writing?

This strategy combines the benefits of stock ownership and options trading, and each aspect provides some risk protection for the other. If you write a covered call, you retain your shareholder rights, which means you’ll receive dividends and be able to vote on the company’s direction.

Writing covered calls is a way to receive additional income from stocks you own. It can also offer limited downside protection against unrealized gains on stocks you’ve held for some time since you lock in a price at which to sell the stock, should the option be exercised. You should realize, however, that if a stock on which you’ve written covered call rises in value, there’s a very real chance that your option will be exercised, and you’ll have to turn over your shares, missing on potential gains above the strike price of your option.

What is a Covered Call Strategy?

An investment strategy known as a covered call involves the sale of call options. To increase the income you receive from the shares you already own or recently bought, you can buy against them. The option you sell is “covered” since you have the necessary number of shares to complete the transaction, as stated by the option you sold.

Using the covered call option strategy, the investor can profit by writing calls while still enjoying all the perks of owning the underlying stock. It includes dividends and voting rights unless he receives a written call exercise notice and is required to sell his shares.

The investor gave up a chance to fully profit from a significant increase in the underlying asset’s price in exchange for the premium; therefore, the profit potential of covered call writing is limited. Investors who think the underlying pricing won’t fluctuate significantly soon should use this method.

Why use a covered call?

You might write calls to receive short-term income from the premium you’ll be paid. If that’s your strategy, you anticipate that the option you write will expire out-of-the-money, and won’t be exercised. In that case, you’ll retain all of the premium as profit. If you’ve written this call on stocks you already own, known as a covered call, the premium can act as a virtual dividend you receive on your assets. Many investors use this strategy to earn additional income on non-dividend-paying stocks. Alternatively, you could view the premium as a way to reduce your cost basis or the amount you paid for each share of stock.

If you choose this strategy, you’ll have to keep the minimum cash margin requirement in your margin account to cover the possibly steep losses you face if the option is exercised. In addition, if you are assigned, you must purchase 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’ll have to consider the transaction costs and brokerage fees you pay for opening the position, which will be deducted from the premium you receive. And if your option is exercised, you’ll have to pay another round of fees. But since you probably plan for your option to expire unexercised, if you’re successful, you won’t face any exit transaction fees or commission.

If you write a call on the stock you hold in a margin account, you should consider the margin requirement imposed by your firm when calculating return. If your trade is successful, you retain all of your capital, but it will be tied up in the margin account until expiration. That means you can’t invest it elsewhere in the meantime.

Suppose you have written an option on a stock with an upcoming dividend distribution. In that case, it’s essential to know that the likelihood of exercise is much higher right before a dividend payout. If the stock’s dividend date on a call you’ve written is approaching, you should re-evaluate and determine whether to close out your position.

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

Wishing you a great week!