Writing covered call options: an introduction

24 August 2020 by Montreal Exchange
An Introduction to Writing Covered Calls

Perhaps you would like to start using options, but you do not know which strategy to implement? The simplest and most popular strategy among individual and institutional investors is covered call writing.

This article is the first in a series of four articles on covered call writing. It covers the basic features of this strategy and why it is used. The second article will discuss how to use the strategy to sell securities held. In the third article, the focus will be on using the strategy to generate income, and the fourth and final article will examine the issues to consider when implementing the strategy.

What is covered call writing?

Obligations of the call option writer

The writer of a call option has an obligation to sell 100 units of an underlying security (for example, a share) at the strike price if the holder exercises the option before it expires. In exchange for contracting this obligation, the option writer receives a premium paid by the buyer.

Covered call writing is a strategy that consists of writing one call option contract for every 100 securities (shares of a company or units in an exchange-traded fund) held in a portfolio. The investor receives a premium for writing the call options, and if the price of the underlying security falls, the options protect the investor in an amount equal to the premium received. This premium effectively reduces the cost of acquiring the shares by the same amount. In exchange for these benefits, the investor agrees to sell his or her securities at the exercise price (i.e. the strike price) if the holder of the call options decides to exercise them. As a result, the investor agrees not to benefit from any increase above the strike price until the expiration date of the call options.

Why write covered calls?

There are three main reasons for implementing this strategy. 

- The first is to obtain protection against an expected moderate decline in the price of the underlying asset. 

- The second is to sell the securities held. 

- The third is to generate additional income, either on an ad hoc or systematic basis.

Payoff profile for covered call writing

In the following example, an investor implements the covered call writing strategy by buying 100 shares of ABC at $65/share and writing 1 ABC call option with a strike price of $67 for $1.50. The total premium received is $150 per option contract ($1.50 per share x 100 shares per option contract). In exchange, the investor agrees to sell the 100 shares at a price of $67/share, if the holder of the call options exercises the contract.

 Example of covered call writing
 Purchase of 100 shares of ABC for $65/share
Sale of one call option on ABC at a $67 strike for $1.50
 Example of covered call writing
 Purchase of 100 shares of ABC for $65/share
Sale of one call option on ABC at a $67 strike for $1.50

Writing covered calls

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Maximum profit

The strategy’s maximum profit of $350 is equal to the $67 strike minus the $65 price of the stock plus the $1.50 premium received, for a total of $3.50 per share, multiplied by 100 shares per contract.

($67-$65+$1.50 )×100=$350

Break-even price

The break-even price of $63.50 is obtained by subtracting the $1.50 premium received from the price of $65/share.

$65-$1.50=$63.50

Maximum loss

The maximum loss for the strategy is very high, but the risk to the investor is not more than the risk of simply holding the shares. The maximum amount at risk per share corresponds to the break-even price of $63.50, as calculated above, compared to $65 per share for simply holding the shares. So as you can see, the amount at risk in writing covered call options is slightly lower than the risk incurred when simply holding the shares. The protection obtained corresponds to the premium received, i.e. $1.50 per share.

Protection level

As mentioned above, the premium collected from writing call options reduces the effective acquisition cost of the underlying shares. The value of the premium therefore provides some protection against the share price falling. An investor who expects the price of a security to fall must therefore estimate the size of this potential decline before making a decision on the strategy. If the drop is expected to be large, the investor might be better off simply selling the stock. However, if the investor expects a moderate decline or a stable price over a more or less long period of time, writing covered call options may help reduce the impact of this decline, in whole or in part. It will all depend on the strike price  chosen. For more protection, the investor could select a strike price that is lower than the price of the underlying security; this is known as an “in-the-money” call. The more the call option is in-the-money, the higher will be the premium and, consequently, the greater the protection provided by the option.

Conclusion

When executing the covered call writing strategy it is important to understand the market environment. In a very bullish market this strategy tends to generate a smaller profit than simply holding the shares, because the maximum profit is limited to the strike price of the calls written. The strategy’s return therefore depends on our ability to properly assess market conditions. But this is the case for each of our investments. The ideal context for executing this strategy is when we expect the price of the underlying security to remain relatively unchanged or fall slightly over a period of time. The objective of the strategy is to see the call options you have written expire worthless. If this happens and your expectations are unchanged, you can sell more calls, further reducing the cost of your underlying assets. The next article will discuss how to implement this strategy to sell our securities.

Before you start using the strategies mentioned in this article, we suggest that you test them using the Montréal Exchange’s trading simulator.

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1 We will cover the choice of strike price in more detail in the fourth article.

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