Options 101: The Covered Call / Buy-Write Strategy

For better or worse, most investors purchase stocks with the intent of holding their shares for an extended period of time. We do this mainly because the media and industry professionals have drilled into our heads, year after year, time after time, that it's best to buy and hold. The recent bull market phenomenon also fueled this mindset because the ‘buy and hold' strategy worked extremely well - for a while. Whether or the not the ‘buy and hold' strategy is still the most efficient way of investing remains a topic for discussion. However, it is still the strategy that most investors are comfortable with and tend to follow. The first strategy we will discuss is a hybrid of the buy and hold strategy, one that provides for better and more consistent returns a large majority of the time when compared to plain stock ownership alone.When we buy a stock, there are three possible outcomes. It can go up, down, or sideways. Two of these scenarios are negative (when the stock moves down or sideways) and only one outcome is positive (when the stock goes up).Why is it negative when the stock moves sideways? While you do not have a capital loss, you do have an opportunity cost. The money invested in your stagnant stock could be making you money if somewhere else but you also incurred commission costs on both the way in and way out.For the sake of description, we will identify the three potential scenarios as the "up" scenario, the "down" scenario and the "stagnant" scenario. By employing the covered call strategy, you can change the outcome of the scenario profile so you have two positive potential results instead of only one.By employing the covered call, we still have the "up" scenario as a positive result, but now the "stagnant" scenario will also produce a positive result since we collect a premium and the third scenario, the "down" scenario will not be as negative. Let's take a closer look at the covered call strategy and its construction. There are two components of the covered call strategy, the stock component and the option component. The stock component consists of a long stock position (you own stock). The option component consists of selling one call per every one-hundred shares of stock owned.Remember, one option contract is worth one hundred shares of stock. So for example, 1000 shares of stock equals 10 call contracts or 200 shares equals 2 call contracts. The chart below shows more examples of the proper construction of covered call. Please take special note that the ratio of stock to calls must be exactly 100 shares to 1 option contract. Number of Shares Owned Call Contracts to Sell 100 1 300 3 1700 17In other words, to find the maximum number of calls you can sell, you simply divide the number of shares you own by 100.The philosophy behind the covered call strategy is not complicated. It entails using a long stock position along with a short call option to create a positive stream of additional income, much in the same way a person would purchase a house and then lease it out to collect rent in order to pay for the mortgage. Another analogy is that of the insurance company. An insurance company receives premiums month in and month out. Over a period of time, this constant stream of income easily builds to a point where it outweighs any pay out the insurance company may face, even for catastrophic events. The constant and recurring collection of option premiums works better if done over longer periods of time (for example, one year). That time frame allows the odds to play into your favor. Now let's talk about the odds. There have been several studies done on the topic of premium buying versus premium selling. The goal of the studies was to determine whether it is better to buy options or sell options.<<click here to see our covered call case study>> Phil, please link to "Covered call case study file"Recent studies have found that selling the premium was the correct trade 78% to 83% of the time. That is a very high percentage and is worth taking advantage of when a good opportunity presents itself. The covered call strategy takes advantage of the fact that an option is a depreciating asset because its extrinsic value (time value) goes to zero at expiration. The process by which an option's extrinsic value dissipates is called time decay.Time decay, also called theta, is defined as the rate by which an option's value erodes into expiration. The value of the option over parity to the stock is called extrinsic value, or time value. For example, if a stock is $53 and a call option with a strike of $50 is trading for $4, there is $3 of intrinsic value and $1 extrinsic, or time value. If the option were to expire immediately, it would be worth $3 since there is a $3 benefit to owning the $50 call when the stock is trading for $53. If the option were trading for $3, we say it is trading at parity; that is, it is equivalent to owning the stock at that moment.Since an option has a limited life, it is a wasting asset. This means the extrinsic value in the option will wither away daily until expiration. This "decay" is not a linear function meaning it is not equally distributed between all of the days to expiration.

As the option gets closer to expiration, the daily rate of decay increases and continues to increase daily until expiration of the option. At expiration, all calls and puts must be completely devoid of extrinsic value as noted in the time value decay charts below.

As more time goes by, the options extrinsic value decreases. Again, it is important to note that the rate of this decrease is not linear, meaning not smooth and even throughout the life of the option contract.An option contract starts feeling the decay curve increasing when the option has about 45 days to expiration. It increases rapidly again at about 30 days out and really starts losing its value in the last two weeks before expiration. This is like a boulder rolling down a hill. The further it goes down the hill, the more steam it picks up until the hill ends.

Since a covered call writer buys the stock and sells the call, the writer captures the extrinsic value in the option by holding the short call until expiration. In the covered call strategy the option's time decay works to the seller's advantage in that the more that time goes by, the more the extrinsic value decreases.

Key Point -- The covered call strategy provides the investor with another opportunity to gain income from a long stock position. The strategy not only produces gains when the stock trades up, but also provides above average gains in a stagnant period, while offsetting losses when the stock declines in price.We have now seen how a covered call strategy is constructed and how it is supposed to work. Let's take a look at some examples.Example 1You own 1000 shares of Oracle at $9.50. The stock has been stuck around this level for a long time now and you have grown impatient. You finally give in and sell 10 one-month at-the-money calls. The at-the-money call is the one whose strike price is nearest the current stock price. With Oracle trading for $9.50, we'd want to sell the $10 call, which we'll assume is selling for 50 cents. You sell the calls at a 50-cent premium per contract which creates a $10.50 breakeven point on the call. Let's look at what our returns will be in each of the three scenarios.

The "Up" Scenario

In the "up" scenario, the maximum gain that can be attained is the stock finishing at $10.00 or higher. At a stock price of $10, you gained 50 cents of capital appreciation (paid $9.50 and it is worth $10). You also gained 50 cents from the sale of the call for a total gain of $1.00. This represents a 10.52% one-month return (paid $9.50 and will collect $10.50 is sold) or an annualized return of 126.32%. It is not realistic to expect this type of return every month but remember that recent studies show that premium selling works approximately 80% of the time, which is still very good. We stated earlier that the maximum return of this buy-write will be realized when the stock reaches $10.00 or higher with the maximum return of $1.00. What happens if the stock closes higher than $10 at expiration?As the stock goes higher, the option will earn less in direct proportion with the increase in capital appreciation. For example, if the stock closes at $10.30 you would receive only 20 cents from the option. The option would now be worth 30 cents because with the stock at $10.30, the 10 strike call would have 30 cents of intrinsic value. Since you sold the option for 50 cents, you would see a 20-cent profit (50 cents -- 30 cents = 20 cents). Since you bought the stock at $9.50 and it is now $10.30 you have 80 cents of capital appreciation. Combine that with the option profit and you're left with a $1.00 profit. Let's look at what happens when the stock trades up to $12.00 and see if you again have a $1.00 return on the position. At $12.00, the option will have $2.00 of intrinsic value (stock price -- strike price) because it is in-the-money. You sold the option for 50 cents so you have a $1.50 loss. However, you bought the stock for $9.50 therefore you have a $2.50 capital gain. Combined, you have a $1.00 profit. The bottom line is this: No matter how high the stock closes, you have given someone else the right to buy your stock for $10, which represents a 50-cent capital gain. Because someone paid you 50 cents for that right, the most you could ever make is a $1.00 profit.

Please refer to the chart below for examples of total dollar profits per number of contracts, remembering that each contract controls 100 shares of stock.

Number of Contracts	Capital Appreciation	Profit Per Contract	Total Dollar Profit
1	.10	.50	$60.00
5	.10	.50	$300.00
10	.10	.50	$600.00
20	.10	.50	$1,200.00
50	.10	.50	$3,000.00
100	.10	.50	$6,000.00

Observe that if the stock closes over $10.00, then your stock will be called away because your short calls will be exercised. This is correct but we will talk about position management later. For now, let's get back to our three scenarios.

In the "up" scenario, you would profit with the buy-write even if the stock is up by as little as a penny, but you are also limited on our maximum profit. You are limited on your maximum profit as defined by the formula below: Maximum Profit = Strike Price + Option Price -- Stock Price.This method of calculation will work every time. As you see, the buy-write has a positive but limited upside potential.

The "Stagnant" Scenario

When we apply the covered call strategy to the stagnant stock scenario, we take a negative return scenario and turn it into a positive scenario. Remember, when we sell an option, we receive a premium for doing so. When the stock does not move during the option's life, the extrinsic value of the option goes to zero. The amount of money paid for the option goes to the seller.We'll take a look at how this sets up. Let's go back to our previous example with the stock trading at exactly $9.50. We sell the front month, at-the-money call, which would be the $10 strike call and receive 50 cents. As time goes by, there is less chance for the option to become "in-the-money." As this happens, the extrinsic value lessens and finally, after Friday expiration, the option is worthless. The stock finishes at $9.50 and you have received no capital appreciation but you have received the full 50 cents of extrinsic value from the option sale. If the studies are correct and selling the premium works 80% of the time, then you will collect approximately $4.00 per contract sold over the course of the year. As the examples demonstrate, writing covered calls against a stagnant stock can provide you with an acceptable return instead of frustration, wasted time and capital.

The "Down" Scenario

In the final scenario, where your stock purchase is headed down into negative territory, the covered call strategy can help minimize your losses. Although picking losers and incurring losses is inescapable, it can be minimized and controlled. Let's take a look at how the buy-write can help us do that. Continuing with our previous Oracle example, let's assume you bought the stock for $9.50 and at the end of the month the stock had traded down to $8.50. You would have a $1.00 loss on your investment.However, if you had sold the $10 strike calls for $.50, you would only have a 50-cent loss. You would have a $1.00 capital loss in the stock, but a 50-cent option gain from selling the option. If you were going to buy the stock anyway and incur a possible loss, it is better to take a 50-cent loss than a $1.00 loss. In this down scenario, the option premium received helped to offset the capital loss. If the stock is down more than the amount you received for selling the call, then the option premium serves as an offset to the loss of the stock. However, you can still make money in the "down scenario" using the covered strategy if the stock is only down a small amount. There is a scenario in the buy-write strategy where you can profit from owning a stock that is lower than where you bought it. Going back to the previous example, you bought Oracle for $9.50 and sold the $10 strike calls for 50 cents. At expiration, the stock finishes down $.20 at $9.30. You would have incurred a $.20 loss on your stock. However, had you sold the $10 call for 50 cents, you'd still be up with a 30-cent gain on a stock that went down in price.To recap: In the "down scenario," your loss will be offset by the option premium you received so your loss will not be as severe. You still may incur a loss, but it will be minimized, and minimizing losses is a key to successful investing.

For a complete breakdown of these three scenarios, please refer to the table below.

Covered Call Example Return Table
Stock Price	Stock P & L	Option P & L	Total P & L
12.00	+2.50	-1.50	+1.00
11.50	+2.00	-1.00	+1.00
11.00	+1.50	- .50	+1.00
10.50	+1.00	0	+1.00
10.00	+ .50	+ .50	+1.00
9.75	+ .25	+ .50	+ .75
9.50	0	+ .50	+ .50
9.25	- .25	+ .50	+ .25
9.00	- .50	+ .50	0
8.50	-1.00	+ .50	- .50
8.00	-1.50	+ .50	-1.00

The Buy-Write

We've talked about covered calls and how they can provide positive returns whether the stock rises, falls, or moves sideways. Of course, this is not to say that you cannot lose on a covered call. Covered calls lose when the stock falls by an amount greater than the premium received. But for those investors who like covered calls, you can enter an order to simultaneously execute the purchase of the stock and sale of the call. This is done with a buy-write. The buy-write is an order to "buy" the stock and simultaneously sell or "write" the call option. Buy-writes can provide for better prices since you are giving the market maker two orders rather than one. Buy-writes also reduce "execution risk." Execution risk is where the price moves between the purchase of the stock and the sale of the call. For example, it is possible that you buy Oracle for $9.50 but then have the stock drop slightly while waiting for the confirmation. By the time you enter the order to sell the $10 call, it has fallen in price and you end up receiving something less than the expected 50 cents. This is execution risk. By entering both orders together, the buy-write eliminates the time between executions. If you are an avid covered call user, check with your broker to see if they allow buy-writes as the benefits can really add up over time.

<< For more information on buy-writes, please click here >>

Lean

Now that we have discussed how to construct a covered call and how it will provide returns in the three different scenarios, I would like to talk about lean.Professional traders use the term "lean" to refer to one's perception about the directional strength of the stock. When you own a stock and intend to hold it for a period of time, you are aware that you will probably be holding it while it goes up and while it goes down. This means that at any given moment in time, you might have a different opinion of the potential movement of that stock. Knowing this, there is a way to address your present level of confidence or "lean." You do this by your choice of which option you sell. While it is true that the at-the-money option has the most amount of extrinsic value (time value), it might not always be the ideal option to sell in every situation. For instance, if you feel that the stock has a very high chance of rising, then you may wish to sell an out-of-the-money call. In doing so, you allow yourself a little more room for capital appreciation. For example, let's say the stock is trading at $27.00. Normally, you would sell the at-the-money $27.5 calls at, say $1.00. If the stock were to rise quickly to $28.50 then your position would have maxed out at $28.50, and you would have a $1.50 gain over the one-month period. You paid $27 and got paid $1 to sell for $27.50, which is a $1.50 gain.Not bad. But if the stock went to $29.50 then you would have missed out on another $1.00 profit. If you feel that the stock was poised for such a move, you may decide to sell the $30 calls for 30 cents. You'd receive less premium (30 cents rather than 50 cents) but allow for more capital appreciation (have the obligation to sell for $30 rather than $27.50). If the stock closes at $29.50, you'd make $2.50 in capital appreciation and $.30 in option premium for a total of a $2.80 return. That's much better than the $1.00 total return from selling the $27.50. So, if you feel the stock has a real good shot at taking a run up, you can lean your position long by selling an out-of-the-money call. If you have a more neutral view on your stock you would sell an at-the-money-call in order to receive a bigger premium which allows for greater downside protection if the stock trades down and higher potential profit if the stock becomes stagnant. Leaning also works on the downside. If, by chance, you feel that the stock may trade down a bit during the life of the option, then you can sell an in-the-money-call. The effect of this would be to provide you with a little extra premium to cover more downside risk. Remember when you sell an option you seek to capture extrinsic value. An in-the-money option not only has extrinsic value but also some intrinsic value. When you feel that you want to lean your covered call strategy a little short, choose to sell an in-the-money call so you can also have some intrinsic value to cover your downside. As an example, say your stock is trading at $29.00 and you feel that your stock may trade down a little but still remain in an uptrend. You don't want to get rid of the stock but you also don't want to lose any money so you sell the 27.5 call at $2.00. The stock starts to trade down and finishes at $26.00. If you had only owned the stock then you would have lost three dollars since you owned the stock at $29.00 and it closed at $26.00 on expiration.However, because you sold the 27.5 calls at $2.00, you would only realize a $1.00 loss in the stock. The premium received will offset the loss due to the fact that you identified and adjusted for a likely move. As you can see, the buy-write strategy can be altered to fit any directional view you have on your selected stock.Finally, if you intend to use the buy-write strategy successfully, you generally need to sell the calls against your stock on a consistent, recurring interval, over a period of time. This means that you will have to be prepared to "roll" your calls out to the next month come expiration. Sometimes, all you'll need to do is to sell the next month out call.Rolling is defined in options as moving a position from one strike to another either vertically in the same month (for example, from the $50 to the $55), horizontally to another month (for example, from May to June) or some combination thereof. Other times, you may have to buy your short call back so that you will not lose your stock. Sometimes, you may even want to allow the stock to be called away if you have decided that the stock has reached a level were you want to take your profits and begin to look for another opportunity.The term "roll" means to move your position either out to the next strike or to move your position up or down a strike in the same month. The term "roll" means "to move."Rolling is normally done via time spread and/or vertical spreads. Without getting into the trading of spreads, which is a unique strategy in itself and a strategy covered in the Directional Corner, we will talk a little about the "roll."As stated before, the covered call strategy is most effective when executed month in and month out over an extended period of time. In order to do this, an investor must re-initiate the position every month at the option's expiration. The re-initiation of the position every month is where the term rolling comes from. However, there may be times when you may want to give yourself a little more upside room for capital appreciation. In those rare cases, you will not want to "roll" the position, because it might be called away if the call you sold is exercised when it becomes ‘in the money.'When an option's expiration approaches, your short option can either be in-the-money or out-of-the-money. As we discuss the two potential outcomes, let's first assume that we want to hold onto our stock. If the option is going to finish out of the money, you would let it expire worthless and then sell the next month's call. If the option is going to expire in-the-money and you want to keep the stock you will need to buy the short option back and sell the next month's call. This trade will consist of two option trades. You will be buying one option and selling another, which is commonly known as a spread and is referred to as a single trade.So, when you roll out your covered call or buy-write, you do it by doing a spread. The front month option, the one that you happen to be short, will be bought back thus ensuring you keep your stock. The second month option will be sold short thus re-initiating your covered call strategy. The position that remains is long stock and short calls. As far as the selection process of the spread used for the rolling of the position, there will be some choices.Of course, there is no choice as to the front month option, you must buy back the option you are short. However, you do have a choice as to the next month option you are going to sell, whether it be near term or farther out in expiration. This goes back to our earlier conversation about lean. If you are no longer bullish then you would not have bought back your short call and instead allowed it to be exercised and have the stock called away from you. If you choose to roll the position then you must be somewhat bullish on the stock. Your lean will dictate to you which new option to sell.

Now, let's look at some chart examples of the covered call strategy. For additional examples, refer to our other article

<< Please click here "Covered Calls: A Case Study >>

It features an in-depth look at a one year case-study comparison between five randomly selected long stock positions, and those same positions with calls sold against them.

For now however, let's look at these four good candidates for the Covered Call / Buy Write Strategy.

MCD Daily Chart -- Covered Call Example #1

Source: Quote.com^®

NOTES ON McDONALD'S (MCD)

Covered Call

1. Around June 2, 2003, MCD breaks out through a resistance level established back in late Nov. early Dec. 2002 after failing to break that resistance level in mid May 2003.

2. MCD climbs up from $20.00 to the $25.00 range in a slow gradual uptrend step like pattern. This type of pattern is an opportunity for buy-writers because this type of gradual rise normally brings about a decreasing implied volatility period which is great for premium selling.

3. Notice the size of the daily vertical lines during the period from mid-August 2003 to December 2003. The size of the lines represents the daily trading range of the stock. As you can see, the lines are very short which indicates that the stock does not move much intra-day. Again, this is an indication of decreasing volatility which is a positive sign for buy-writers.

Conclusion: The two most prominent and noticeable patterns both bode well for buy-writers. The covered call strategy does not need a lack of movement, as much as slow, consistent non-volatile movement. So, in the case of McDonalds above, the slow trending movement of the stock brings about a decreasing volatility. Added to this is the contraction of intra-day movement, as shown by the decreasing range of daily trading.

These two factors each contribute to decreasing volatility and provide an opportune time to write a covered call. This is the type of pattern that offers both capital appreciation as well as premium returns.

JPM Daily Chart -- Covered Call Example #2

Source: Quote.com^®

NOTES OF J.P.MORGAN (JPM)

Covered Call

1. By June of 2003, JPM had traded up from a lower trading range in the $25.00 area to a new range around $35.00.

2. Since entering the new trading range in June, the stock has consolidated into a relatively flat, horizontal trading channel. For the most part, this channel is only around $3.00 to $4.00 wide.

3. This trading channel is not only tight, but it seems to be equally dispersed around the $35.00 mark. The stock does not seem to venture very far on either side of $35.00.

4. From the time that the stock enters the trading channel, the range of the channel has been decreasing or tightening, which indicates decreasing volatility.

Conclusion: JPM sets up a classic text book buy-write opportunity above. After finding a new trading range, the stock consolidates into a tight, trading channel that is almost horizontal. Further, this channel tightens and does not deviate from $35.00 to the point where it even comes close to a channel line violation.

Here, an investor would most likely be interested in writing the 35 strike price calls to collect premium as the stock trades sideways. Obviously, there is no way to predict how long a stock will consolidate like this, but the risks are low, and in this case -- the covered call strategy would have returned some very nice, low risk returns over this period.

DELL Daily Chart -- Covered Call Example #3

Source: Quote.com^®

NOTES ON DELL COMPUTER (DELL)

Covered Call

1. After dropping out of a higher trading range, Dell trades down throughout the months of December 2002, January 2003 and into mid-February 2003 before bottoming out. During this period of time, the drop was a low volatility, gradual one in which the stock loss could have been well offset by premium collection.

2. After rebounding off a low around $22.50 in mid February, Dell rebounded quickly to the $26.00 -$27.00 level where it consolidated until mid-March. The stock traded in a tight band until starting to trade up.

3. After the consolidating period, Dell began a slow, deliberate rise over the course of the next 9 months or so, with most months showing an overall trading range of $2.00 or less. The long, slow, step like growth pattern can be seen both in the daily trading ranges, as well as in the monthly trading ranges. This is very favorable to writing covered calls.

Conclusion: Dell spent the better portion of nine months trading up in a manner that is suggestive of decreasing volatility. Because the stock was in an up trend, and a gradual one at that, a buy-writer would have been able to profit from capital appreciation as well as a having a good chance at seeing a positive return in terms of the collection of premiums.

Furthermore, during Dell's down cycle, the stock traded down slowly enough to be able to receive several months of premium. This should have, at least partially, offset enough of the loss to allow the trader time to profit from the subsequent recovery.

FON Daily Chart -- Covered Call Example #4

Chart Provided by Quote.com

NOTES ON SPRINT (FON)

Covered Call

1. After a large drop at the end of Jan 2003, Sprint consolidates around $12.00 and trades in a relatively tight range, around $12.00, for approximately 5 months or until mid-May 2003. This period is the first opportunity for premium collection.

2. At the end of May 2003, Sprint trades up to the top of its trading range in a slow, methodical way, indicating a period of decreasing volatility

3. Sprint breaks out of old trading range by trading through resistance set by the 2 highs in February, around $13.25. It develops a new trading range at the $15.00 level by trading up in a slow, step like pattern which also indicates a period of decreasing volatility.
4. Sprint trades around the $15.50 range and really tightens up around October 2003 thru January 2004. This again, is a long period of decreasing volatility.

Conclusion: Sprint shows two favorable patterns here that are friendly to covered call writing. The first is that Sprint shows the tendency to trade in a tight range for extended periods of time, as seen in February through May 2003 and July through December 2003. This is advantageous for premium collection.

The second is that when Sprint does move, it mostly trades up in a slow, directional type of move, as opposed to gapping (with the exception of Jan. 2003). These slow upward directional moves work well for covered call writers in two ways; capital appreciation and premium capturing.

You may feel overwhelmed after reading this article. However, with a little help from us and a little time, we will be able to make you fluent in this strategy. As you can see, this strategy can offer more consistent profits, monthly income, less risk and is a natural match for the buy and hold philosophy that you're already practicing.