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Pay yourself the dividend yourself! - What is the covered call strategy?
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Pay yourself the dividend yourself! - What is the covered call strategy?

created Forex Club19 March 2021

Covered call is a very simple and old option strategy that allows you to earn additional income from your equity portfolio. Covered call involves writing a call option against your shares. By writing a call option, the investor undertakes to sell the shares at a specified price on a predetermined date. 


READ NECESSARY: What are options - an introduction


This is a strategy that is used quite often by institutional investors, who thus obtain additional income from their equity portfolio. At first glance, the strategy seems counterintuitive. Why commit to selling shares that an investor wants to hold for the next few quarters or years?

The goal of the strategy is not to sell the shares, but to generate profit from writing the options and wait until they expire worthless. As a result, the investor obtains additional profit from selling "insurance" to other market participants. The key to this strategy is writing options that have little chance of expiring with value.

Covered call strategy

As with any strategy, the ratio of reward to potential risk is crucial. The more an investor wants to achieve a higher premium from writing a call option, the greater the risk of being deprived of significant profits in the event of a sharp increase in the equity portfolio. For this reason, the greatest "cost" of a strategy is the risk of losing profits from the potential appreciation of the investor's assets. Depending on the investor's strategy, covered call may take the following form:

Long position + issuing ATM call option

ATM call option (At-the-money) has an exercise price around the current market price of the underlying. As a result, the writer of the option undertakes to sell the shares at a price close to the market price. Thanks to this, he receives a premium that is paid by the other party to the transaction. 

An example is issuing a call option on Amazon stocks. At the end of the trading session on March 5, the value of one share is $ 3. An investor issues a call option to his portfolio of 000 shares, which expires on June 100, 18. The option exercise price is $ 2021. The option premium is $ 3. With this transaction, he receives $ 000, which is the maximum profit from the said transaction. At the same time, the strategy covers losses to the level of $ 214,4. The maximum profit per transaction is $ 21.

Share price Profit / loss on shares Profit / loss on options Profit / loss on the strategy
2500 - $ 50 + $ 21 440 - $ 28
2700 - $ 30 + $ 21 440 - $ 8
3000 0$ + $ 21 440 + $ 21 440
3200 + $ 20 000 + 1 440 $ + $ 21 440
3500 + $ 50 000 - $ 28 + $ 21 440

Source: own study

Long position + OTM call option

OTM call option (out-the-money) has an exercise price above the current market price. The probability of exercising the option is lower than with the ATM option. As a result, the received bonus is  lower than in the case of ATM. The "cost" of such a strategy is much less protection against a potential downside. The benefit of writing an OTM option is a much higher potential profit. At the same time, the chance of worthless options expiring increases.

An example is issuing a call option to Amazon stock. At the end of the trading session on March 5, the value of one share is $ 3. An investor is putting up 000 shares in his portfolio on a call option expiring on June 100, 18. The option exercise price is $ 2021. The option premium is $ 3. With this transaction, he receives $ 200. The maximum profit from this strategy is $ 129,55. At the same time, the strategy covers losses to the level of $ 12.

Share price Profit / loss on shares Profit / loss on options Profit / loss on the strategy
2500 - $ 50 + 12 955 $ - $ 37
2700 - $ 30 + 12 955 $ - $ 17
3000 0$ + 12 955 $ +12 955 $
3200 + $ 20 000 + $ 12 955 + $ 32
3500 + $ 50 000 - $ 17 + $ 32

Source: own study

Long position + ITM put option

An ITM (in-the-money) call option has an strike price below the current market price. The probability of exercising the option is higher than in the case of ATM and OTM options. As a result, the received bonus is  much larger than the previous two types of options. The benefit of writing an ITM option is much greater protection against declines. The "cost" of the strategy is to significantly reduce the potential gain from stock appreciation.

An example is issuing a call option on Amazon stocks. At the end of the trading session on March 5, the value of one share is $ 3. An investor is putting up 000 shares in his portfolio on a call option expiring on June 100, 18. The option exercise price is $ 2021. The option premium is $ 2. With this transaction, he receives $ 720, which is the maximum profit from the said transaction. At the same time, the strategy covers losses to the level of $ 385,95. The maximum profit per transaction is $ 38.

Share price Profit / loss on shares Profit / loss on options Profit / loss on the strategy
2500 - $ 50 + $ 38 595 - $ 11
2720 - $ 28 + $ 38 595 + $ 10
3000 0$ + $ 10 595 + $ 10
3200 + $ 20 000 - $ 9 + $ 10
3500 + $ 50 000 - $ 39 + $ 10

Source: own study

Covered call summary

The covered call strategy is the simplest strategy to generate additional income from your equity portfolio. Depending on the type of call option, the premium obtained has a different value.

Writing a call option that is OTM generates a small profit in the case of expiry of the option with no value. This offers little protection against a fall in the value of the stock, but has a lot of potential for portfolio appreciation.

Issuing a call option, which is ATM, generates a greater profit in the case of expiry of the worthless option than in the case of an OTM option. This offers decent protection against a fall in stock values ​​and little potential for an upside basket of stocks.

The sale of an ITM call option generates a greater profit in the event of expiry of the worthless option than in the case of OTM and ATM options. This gives a very good advantage before the stock price declines and very little potential for an increase in the basket of stocks.


READ ALSO: Options - what is the Married Put strategy?


Issuing a put option as an alternative to covered call

Developing a covered call strategy is quite a "capital intensive" strategy. Requires buying a portfolio of shares (long position) and writing a call option. A cheaper alternative is to issue a put option, which provides partial protection against declines and gives a minimum potential for profit. The maximum profit is equal to the premium received from the issued put option.

Put ITM options

The ITM put option means that the strike price is higher than the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 3. The price for this option was $ 200 per share on March 5, 2021. This means that the maximum profit is $ 324,55 on each share. This is the equivalent of having a long position and issuing an OTM call option.

Share price Stock price change Option premium Profit / loss on options
2500 - $ 70 +32 455 $ - $ 37
2700 - $ 50 +32 455 $ - $ 17
3000 - $ 20 +32 455 $ + $ 12
3200 + $ 20 000 +32 455 $ +32 455 $
3500 + $ 50 000 + $ 32 +32 455 $

Source: own study

Put ATM options

The ATM put option means that the strike price is close to the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 3. The price for this option was $ 000 per share on March 5, 2021. This means the maximum profit is $ 209,85 on each share. This is the equivalent of having a long position and issuing an ATM call option.

Share price Stock price change Option premium Profit / loss on options
2500 - $ 50 + $ 20 - $ 29
2700 - $ 30 + $ 20 - $ 9
3000 0$ + $ 20 + $ 20
3200 + $ 20 000 + $ 20 + $ 20
3500 + $ 50 000 + $ 20 + $ 20

Source: own study

Put OTM options

The OTM put option means that the strike price is lower than the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 2. The price for this option was $ 700 per share on March 5, 2021. This means the maximum profit is $ 97,6 on each share. This is the equivalent of having a long position and writing an ITM call option.

Share price Stock price change Option premium Profit / loss on options
2500 - $ 20 + $ 9 - $ 10
2700 0$ + $ 9 + $ 9
3000 + 30 000 $ + $ 9 + $ 9
3200 + 50 000 $ + $ 9 + $ 9
3500 + $ 80 000 + $ 9 + $ 9

Source: own study

Summation

The covered call strategy is sometimes used by investors who take a long-term approach to investing. By issuing a call option, the investor can obtain additional income from the share portfolio. For the willingness to sell his shares at a certain price, the investor receives a bonus.


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In the event that the option expires worthless (a fall in prices, a sideways trend or a slight rise in the underlying), the investor improves his position performance. The cost of such a strategy is to agree to sell the stock at a certain price. "Potential profits are cut" in the event of a sharp rise in the share price. An alternative to the covered call strategy is to issue a put option without coverage. This is called "Synthetic covered call strategy".

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Forex Club
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