Writing Covered Calls

Many traders use covered writing to enhance the returns from their long stock portfolios. A covered write is the sale of a call option “against,” or “covered by” a long position in the underlying security. When you sell calls against your stocks, you are giving someone the option of buying your stock from you any time during the life of the option for a stated price--the strike price--of the option. In return for giving up all possible gains above the strike price you receive cash for the options you sold.

Option sellers are said to be "writing" options because they, conceptually, originate the contract(s)--not that anybody ever sees actual paper contracts.

In times when stocks move in a sideways, slightly downward pattern, covered writers benefit greatly from the additional income generated by the sale of call options.

When someone tells me they don't trade options because options are too risky, I usually cite the covered write as an example of using options to reduce risk.  And it's true.  The sale of covered calls reduces the risk of a stock portfolio in the sense that returns are not as variable.  In theoretical terms, you have reduced your portfolio's variance.  And returns are enhanced if stock prices remain the same or fall.

However, your calls do nothing to protect you against losses as the market falls.  This is the only "knock" on covered writing--that it takes away your upside and leaves you with the same downside risk as a regular stockholder.

That's true in theory, but we have clients who manage to keep some of their upside potential through careful management of their positions.  How?  By rolling.  After a stock moves up, they re-purchase the short calls (at a loss) and sell new calls at a higher strike.  This allows them to stay in an uptrending stock so that capital gains from the sale of the stock are deferred.  Note that losses from re-purchasing the short options can be claimed immediately.

The other smart thing these clients do is sell when options are expensive.  Option prices fluctuate between periods when they are cheap or dear.  If you focus on selling when options are expensive, it can make a big difference!  Options-trading software can help you know when a stock's options are cheap or dear on a historical basis.  Or, refer to the Most Overpriced Calls page on this site for currently overpriced calls.

At the time of this writing, Home Depot's (HD | Quote | Chart | News | PowerRating) options were expensive.  An analysis shows some excellent potential returns from selling just out-of-the-money calls.

Next time we'll discuss a variation on the covered write strategy, called a covered combo, that gives the investor true downside protection.