March 22, 2016 | by James Behr Jr
One of the principles at Blue Bell Private Wealth Management is minimizing risk while achieving reliable investment returns. For investors looking to reduce risk and increase income, covered call option writing may work well within existing equity portfolios. This strategy can achieve market returns with less risk than the average mutual fund investment. Covered call writing is an option strategy in which call options are sold on stocks or ETFs that are owned within a portfolio. A call option is a contract that gives the holder of the option the right, but not the obligation, to purchase the underlying security at a specified price for a fixed period of time. The writer receives a premium for the option and then has an obligation to sell the underlying security at the strike price if the option buyer exercises the option. If the seller of the call option owns the underlying shares, the option is considered “covered” because the seller has the ability to deliver the shares without having to go out and purchase them in the open market. If the buyer does not exercise the option the seller profits from the premium.
There are generally three strategies when writing covered calls. These strategies consist of writing at the money (ATM), in the money (ITM), and out of the money (OTM) call options. ATM covered call writing is when an investor sells an option with a strike at the current price of the underlying security. In this strategy, the maximum gain is the amount that is received from the premium plus any dividends received from the underlying security. When an investor sells an option with a strike that is lower than the current price of the security it is considered ITM covered call writing. The further in the money, the more conservative the strategy is; however, upside is decreased accordingly. Conversely, OTM covered call writing is a strategy in which an investor sells an option with a strike higher than the current price of the security. This type of investor will profit in the initial upside movement of the stock. The maximum gain is the premium plus the difference between the strike and the current value plus any dividends.
There are several advantages and disadvantages to covered call writing. The premium received from writing call options serves as downside protection, income, and returns with reduced risk. Should the investment decrease in value, a covered call writer does not begin to lose principal until the decline in the investment is greater than the premium received. Still any loss using covered call writing will be less than simply owning the investment. If the investment does not move then you would keep the premium. However, a covered call will have limited profitability if the investment increases because the option writer is required to sell the investment at the strike price. If the investment appreciates substantially you may forgo some gains you would have had if you did not write the call.
The example below is an illustration, as of March 22nd, 2016, showing the profit-loss scenario based on the movement of the SPDR S&P 500 exchange traded fund (SPY):
SPY MAR 2017 @ 205
Buy 500 shares SPY at $204.53
Sell to Open: 5 calls March 2017 @ 205 for $12.01
Example is based on 500 shares at Schwab’s $8.95 commission tier. Includes expected dividend which is based on the current dividend yield according to the SPDR website and assumes no early assignment.
With over 40 years of experience in the options markets, we utilize these strategies in our clients’ portfolios to reduce investment risk in volatile markets, while enhancing returns in flat markets.