Covered Call

The primary motive is to earn premium income, which has the effect of boosting overall returns on the stock and providing a measure of downside protection. The best candidates for covered calls are the stock owners who are perfectly willing to sell the shares if the stock rises and the calls are assigned. Stock owners that would be reluctant to part with the shares, especially mid-rally, are not usually candidates for this strategy. Covered calls require close monitoring and a readiness to take quick action if assignment is to be avoided during a sharp rally; even then, there are no guarantees.

This strategy may be best viewed as one of two things: a partial stock hedge that does not require additional up-front payments, or a good exit strategy for a particular stock. An investor whose main interest is substantial profit potential might not find covered calls very useful. This strategy becomes a convenient tool in equity allocation management.

Since the possibility of assignment is central to this strategy, it makes more sense for investors who view assignment as a positive outcome. Because covered call writers can select their own exit price (that is, strike plus premium received), assignment can be seen as success; after all, the target price was realized. The investor doesn't have to sell an at-the-money call. Choosing between strike prices simply involves a trade off between priorities.

Reading the Words: Call, Strike Price, Premium, Writer and Assignment

An option is the right to buy or sell a specified amount or value of a particular underlying interest at a fixed exercise price by exercising the option before its specified expiration date. An option that gives the right to buy is a call option, and an option that gives a right to sell is a put option. Calls convey to the purchaser the right, but not the obligation, to buy shares, and they convey to the seller the obligation to sell shares if the contract is assigned.

The option holder is the person who buys the right conveyed by the option. A seller of an options contract can also be referred to as the writer of that options contract. The option writer is obligated, if and when assigned an exercise, to perform according to the terms of the option.

In the case of a physical delivery option, the exercise price, which is sometimes called the strike price, is the price at which the option holder has the right either to purchase or to sell the underlying interest. A physical delivery option gives its owner the right to receive physical delivery of the underlying interest, if it is a call, or to make physical delivery, if it is a put, when the option is exercised.

The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. The premium is paid up front to the seller of the option contract and is non-refundable.

The expiration date is the date on which an option expires. If an option has not been exercised prior to its expiration, it ceases to exist, which means that the option holder no longer has any rights and the option no longer has any value. Each American-style option other than a delayed start option may be exercised at any time prior to its expiration. A European-style option may be exercised only during a specified period before the option expires.

A call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option. If the exercise price of a call is above the current market value of the underlying interest, the call is said to be out of the money.

The Options Clearing Corporation, known as OCC, is the options industry clearing house. When an option has been exercised, OCC will assign the exercise in accordance with its rules to a Clearing Member whose account with OCC reflects the writing of an option of the same series.

An option assignment represents the seller's obligation to fulfill the terms of the contract by either selling or buying the underlying security at the exercise price. This obligation is triggered when the buyer of an option contract exercises their right to buy or sell the underlying security. OCC has an established process to randomly assign exercise notices to firms with an account that has a short option position. Once a firm receives an assignment, it then assigns the notice to one of its customers who has a short option contract of the same series. This short option contract is selected from a pool of such customers, either at random or by some other procedure specific to the brokerage firm. For a short equity call, the seller of the option must deliver stock at the strike price and in return receives cash, and each contract represents 100 shares.

If the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, the writer is said to be a covered call writer. The distinction between covered and uncovered call writing positions is important since uncovered call writing can involve substantially greater exposure to risk than covered call writing.

Under Rule 2360(a)(10) of the Financial Industry Regulatory Authority, known as FINRA, the term covered in respect of a short position in a call option contract means that the writer's obligation is secured by a specific deposit or an escrow deposit, meeting the conditions of Rules 610(e) or 610(g), respectively, of the rules of The Options Clearing Corporation, or the writer holds in the same account as the short position, on a unit-for-unit basis, a long position either in the underlying security or in an option contract of the same class of options where the exercise price of the option contract in such long position is equal to or less than the exercise price of the option contract in such short position. Under Rule 2360(a)(36), the term uncovered in respect of a short position in an option contract means the short position is not covered.

How a Covered Call Works

The investor writes the call against stock that the investor buys or owns, and receives the premium for the call. For as long as the short call position is open, the investor forfeits much of the stock's profit potential. If the stock price rallies above the call's strike price, the stock is increasingly likely to be called away.

The main benefit is the effect of the premium income. It lowers the stock's break even cost on the downside and boosts gains on the upside.

Because stock options are not generally adjusted for ordinary cash dividends and distributions, covered writers of calls are entitled to retain dividends and distributions earned on the underlying securities during the time prior to exercise.

Maximum Gain

The maximum gains on the strategy are limited. The total net gains depend in part on the call's intrinsic value when sold and on prior unrealized stock gains or losses. The maximum gains at expiration are limited by the strike price. If the stock is at the strike price, the covered call strategy itself reaches its peak profitability, and would not do better no matter how much higher the stock price might be. The strategy's net profit would be the premium received, plus any stock gains (or minus stock losses) as measured against the strike price.

The potential profit is limited during the life of the option, because the call caps the stock's upside potential. That maximum is very desirable to investors who were happy to liquidate at the strike price, whereas it could seem suboptimal to investors who were assigned but would rather still be holding the stock and participating in future gains. The prime motive determines whether the investor would consider post-assignment stock gains as irrelevant or as a lost economic opportunity.

The best-case scenario depends in part on the investor's motives. First, consider the investor who prefers to keep the stock. If at expiration the stock is exactly at the strike price, then the stock theoretically will have reached the highest value it can without triggering call assignment. The strategy nets the maximum gains and leaves the investor free to participate in the stock's future growth.

By comparison, the covered call writer who is glad to liquidate the stock at the strike price does best if the call is assigned -- the earlier, the better. Unfortunately, in general it is not optimal to exercise a call option until the last day before expiration. An exception to that general rule occurs the day before a stock goes ex-dividend, in which case an early assignment would deprive the covered call writer of the stock dividend.

Maximum Loss

The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor will have lost the entire value of the stock. However, that loss will be reduced somewhat by the premium income from selling the call option.

The risk of losing the stock's entire value is inherent in any form of stock ownership. In fact, the premium received leaves the covered call writer slightly better off than other stock owners.

As stated earlier, the hedge is limited; potential losses remain substantial. The short call option does not increase that downside risk.

Breakeven

Assume the stock and option positions were acquired simultaneously. Break even = starting stock price – premium received.

Volatility

An increase in implied volatility would have a neutral to slightly negative impact on this strategy, all other things being equal. It would tend to increase the cost of buying the short call back to close the position. In that sense, greater volatility hurts this strategy as it does all short option positions.

Considering that the long stock position covers the short call position, assignment would not trigger losses. As for the downside, the premium received buffers the risk from a stock decline to some extent. Increased implied volatility is a negative, but not as risky as it would be for an uncovered short option position.

Time Decay

The passage of time has a positive impact on this strategy, all other things being equal. It tends to reduce the time value (and therefore overall price) of the short call, which would make it less expensive to close out if desired. As expiration approaches, an option tends to converge on its intrinsic value, which for out-of-money calls is zero.

The covered call writer who would rather keep the stock definitely benefits from time erosion. In contrast, for the investor who is anxious to be assigned as soon as possible, the passage of time may not seem like much of a benefit. If the call has not been assigned by expiration, the investor keeps the premium and is free to earn more premium income by writing another covered call, if it still seems reasonable.

Assignment Risk

If the strategy was selected appropriately, there should be no problem here. A covered call strategy implicitly assumes the investor is willing and able to sell stock at the strike price (premium, in effect). Therefore, assignment simply allows the investor to liquidate the stock at the pre-set price and put the cash to work somewhere else.

An investor who has any reluctance about selling the stock would have to monitor the market very closely and stay ready to act (that is, close out) on short notice, possibly having to pay a higher price to buy the call back. Until the position is closed out, there are no guarantees against assignment.

Because call holders may seek to capture an impending dividend by exercising, a call writer's chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches. A situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

For an investor selling American-style options, one of the risks is that the investor may be called upon at any time during the contract's term to fulfill its obligations.

Expiration Risk

For reasons described under assignment risk, there should be no issue with expiration risk, either. If the call is assigned, it means the stock surpassed its target price, which is the strike, and the investor was pleased to liquidate it. If the option is not exercised at expiration, the investor is free to sell the stock or redo the covered call strategy.

There is some risk that a call that expired slightly out-of-the-money may have been assigned.

While the Short Call Is Open

As long as the short call position remains open, the investor isn't free to sell the stock. It would leave the calls uncovered and expose the investor to unlimited risk. Unless they are completely indifferent to being assigned and to the cost of closing out the short position, all investors with short positions must monitor the stock for possible early assignment.

The Covered Call Compared with the Protective Put and the Collar

A long put option added to long stock insures the stock's value. The protective put establishes a floor price under which the investor's stock value cannot fall. In theory, the potential gains on a protective put are unlimited. The protective put buyer pays a premium, which lowers the net profit on the upside, compared to the unhedged stockowner.

A collar writes a call and buys a put with the same expiration as a means to hedge a long position in the underlying stock. The collar strategy essentially adds a long protective put to a covered call strategy. The collar offers more protection than a covered call, but at a lower up-front cost than a protective put.

Tax Treatment: The Qualified Covered Call Provisions

Section 1092 of the Internal Revenue Code defines the term straddle as offsetting positions with respect to personal property. A taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property, whether or not of the same kind. Under Section 1092(a)(1)(A), any loss with respect to one or more positions is taken into account for any taxable year only to the extent that the amount of the loss exceeds the unrecognized gain, if any, with respect to one or more positions that were offsetting positions with respect to one or more positions from which the loss arose.

Section 1092(c)(4) provides that if all the offsetting positions making up any straddle consist of one or more qualified covered call options and the stock to be purchased from the taxpayer under such options, and the straddle is not part of a larger straddle, the straddle is not treated as a straddle for purposes of that section and Section 263(g). A qualified covered call option means any option granted by the taxpayer to purchase stock held by the taxpayer, or stock acquired by the taxpayer in connection with the granting of the option, but only if the conditions listed in the subparagraph are met. Among those conditions, the option must be traded on a national securities exchange which is registered with the Securities and Exchange Commission or other market which the Secretary determines has rules adequate to carry out the purposes of the paragraph, and the option must be granted more than 30 days before the day on which the option expires. The option must not be a deep-in-the-money option. The option must also not be granted by an options dealer, within the meaning of section 1256(g)(8), in connection with his activity of dealing in options.

A deep-in-the-money option is an option having a strike price lower than the lowest qualified bench mark. Except as otherwise provided in that subparagraph, the lowest qualified bench mark means the highest available strike price which is less than the applicable stock price.

Section 1092(f) applies if a taxpayer holds any stock and grants a qualified covered call option to purchase such stock with a strike price less than the applicable stock price. Under paragraph (1), any loss with respect to such option is treated as long-term capital loss if, at the time such loss is realized, gain on the sale or exchange of such stock would be treated as long-term capital gain. Under paragraph (2), the holding period of such stock does not include any period during which the taxpayer is the grantor of such option.

Options Accounts, the Disclosure Document and Sales Practice

Trading options requires specific approval from an investor's brokerage firm. Under FINRA Rule 2360(b)(16)(A), no member or person associated with a member shall accept an order from a customer to purchase or write an option contract relating to an options class that is the subject of an options disclosure document, or approve the customer's account for the trading of such option, unless the broker or dealer furnishes or has furnished to the customer the appropriate options disclosure documents and the customer's account has been approved for options trading in accordance with the provisions of subparagraphs (B) through (D) of that paragraph. Under paragraph (b)(16)(B), in approving a customer's account for options trading, a member or any person associated with a member shall exercise due diligence to ascertain the essential facts relative to the customer, the customer's financial situation and investment objectives.

Under Rule 2360(b)(11)(A)(i), every member shall deliver the current Options Disclosure Document to each customer at or prior to the time the customer's account is approved for trading options issued by The Options Clearing Corporation, other than an OCC Cleared OTC Option. Rule 2360(a)(19) defines an OCC Cleared OTC Option as any put, call, straddle or other option or privilege that meets the definition of an option under Rule 2360(a)(21), and is cleared by The Options Clearing Corporation, is entered into other than on or through the facilities of a national securities exchange, and is entered into exclusively by persons who are eligible contract participants as defined in the Exchange Act. The disclosure document is titled Characteristics and Risks of Standardized Options. Brokerage firms are required to distribute it to options customers. It is not designed to describe the various potential benefits of options or how investors may use options to enhance their investment strategies or to reduce risk.

Rule 2360(b)(19)(A) provides that no member or person associated with a member shall recommend to any customer any transaction for the purchase or sale (writing) of an option contract unless such member or person associated therewith has reasonable grounds to believe, upon the basis of information furnished by such customer after reasonable inquiry by the member or person associated therewith concerning the customer's investment objectives, financial situation and needs, and any other information known by such member or associated person, that the recommended transaction is not unsuitable for such customer.

Regulation Best Interest provides that a broker, dealer, or natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities, including account recommendations, to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

Risks

For the purchaser of an option, the premium paid is the maximum loss. Option holders risk the entire amount of the premium paid to purchase the option, and if a holder's option expires out of the money the entire premium will be lost. Option writers may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses. Uncovered call writing can involve substantially greater exposure to risk than covered call writing.

In a covered call, the maximum loss is limited but substantial, the maximum gains are limited, and the investor forfeits much of the stock's profit potential for as long as the short call position is open.

Options on the Examination

The content outline for the Securities Industry Essentials examination lists options under Topic 2.1.3, Options, in Section 2, Understanding Products and Their Risks. Under that topic the outline lists types of options, puts and calls, and equity vs. index, followed by knowledge of hedging or speculation, expiration date, strike price, premium, underlying or cash settlement, in-the-money and out-of-the money, covered vs. uncovered, American vs. European, exercise and assignment, varying strategies, including long and short, special disclosures, including the Options Disclosure Document (ODD), and the Options Clearing Corporation (OCC) for listed options. Candidates should check the current outline before the examination.

Common Misunderstandings

A covered call is a risk-free way to earn income. The maximum loss is limited but substantial, and the worst that can happen is for the stock to become worthless, with that loss reduced somewhat by the premium income from selling the call option.

The short call adds to the stock's downside risk. The short call option does not increase that downside risk. The risk of loss is directly related to holding the stock.

The investor can sell the stock while the call is outstanding. As long as the short call position remains open, the investor isn't free to sell the stock. Selling it would leave the calls uncovered and expose the investor to unlimited risk.

Assignment can happen only at expiration. For an investor selling American-style options, one of the risks is that the investor may be called upon at any time during the contract's term to fulfill its obligations.

The profit on a covered call has no ceiling. The maximum gains on the strategy are limited, and the maximum gains at expiration are limited by the strike price.

The passage of time works against the covered call writer. The passage of time has a positive impact on this strategy, all other things being equal.

Rising implied volatility helps the covered call writer. An increase in implied volatility would have a neutral to slightly negative impact on this strategy, all other things being equal.

A covered call suits every stock owner. This strategy is not appropriate for a very bearish or a very bullish investor, and stock owners that would be reluctant to part with the shares are not usually candidates for it.

Key Points

A covered call consists of writing a call that is covered by an equivalent long stock position, which provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily forfeiting much of the stock's upside potential.

The maximum gains are limited by the strike price, and the maximum loss is limited but substantial.

Break even equals the starting stock price minus the premium received.

The passage of time has a positive impact on the strategy, and an increase in implied volatility has a neutral to slightly negative impact.

An assignment can occur at any time for an investor selling American-style options, and as long as the short call position remains open, the investor isn't free to sell the stock.

Under FINRA Rule 2360(a)(10), a short call is covered when the writer's obligation is secured by a specific deposit or an escrow deposit, or when the writer holds in the same account as the short position, on a unit-for-unit basis, a long position either in the underlying security or in an option contract of the same class of options where the exercise price of the long option contract is equal to or less than the exercise price of the short option contract.

Trading options requires specific approval from an investor's brokerage firm.