Covered Calls
The covered call is a strategy in options trading whereby call options are sold against a holding of the underlying common stock.
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.
Once a covered writer sells a call option, he creates a range of profitability. If the underlying security stays within this range until the option expires his investment performance will be superior to an investor who just held the underlying security without the covered write. While covered writing does not completely eliminate the risk of holding a stock, the strategy provides a cushion against price declines. It is important to remember that the strategy will out-perform outright stock ownership if the stock falls slightly, remains the same, or rises slightly.
Any time the market price of the underlying security exceeds the exercise price, the likelihood that the option will be exercised and the security will be taken or “called” from the writer increases as well. However, the writer is not bound to hold the position until the option expires. All the writer needs to do is repurchase the option he has written. The repurchase price may be more or less than the price originally received (and therefore may result in a profit or loss), but the obligation to deliver the underlying security is then terminated. The ability to repurchase the option can be effected any time prior to the receipt of an exercise notice.
Ariba believes that the covered call strategy is a good way of increasing cash flow, and at the same time, providing a hedge to some degree against price declines. However, the profit potential of the covered call writing is limited as the investor had, in return for the premium, giving up the chance to fully profit from a substantial rise in the price of the underlying asset.
Please see below for an example. Clients should read an Options Disclosure Document before embarking on this strategy, and are required to complete and sign an options applications form.
(assume we are in the month of September)
XYZ is trading at $17. You purchase 500 shares of XYZ for $17 a share. You sell 5 XYZ October $17.50 calls for $2. (Essentially selling someone the right to purchase your XYZ stock for $17.50 a share in October for a premium of $2.) Technically this means, that you're selling a call (a purchase option for usually 100 shares) with a strike of $17.50 and a premium of $2.
Let's do the math:
Buy 500 shares of XYZ for 17$ - $8,500
Sell 5 call contracts (each for 100 shares) of XYZ at 17.50$ for 2$ +$1,000
Net investment is: $7,500
Now lets look what happens at expiration day.
Scenario A: Stock unchanged
The stock remains unchanged at $17. The calls you sold expire worthless, because why should somebody buy the stock for $17.50 from you when he can buy at the market for just $17?
You keep the premium of 500 x $2 + $1,000
You sell 500 shares of XYZ for $17 + $8,500
With your initial investment of $7500, you have made a return of $1,000 or 13.3% without the stock moving a single tick!
Scenario B: Stock up slightly
The stock of XYZ has moved to $18 at expiration day. You're being 'called' from the owner of the options you sold: you have to sell your XYZ stock to him for $17.50 (the strike of the option you sold). Again, let's look at the return:
You keep the premium of 500 x $2 + $1,000
You sell 500 shares of XYZ for $17.50 + $8,750
With your initial investment of $7500, you have made a return of $1,250 or 16.7%.
Scenario C: Stock down slightly
The shares of XYZ are dropping to $16. What's your result at expiration?
You keep the premium of 500 x $2 + $1,000
You sell 500 shares of XYZ for $16 (the option expires worthless) + $8,000
With your initial investment of $7500, you have made a return of $500 or 6.7% even though the stock price dropped! Actually, we're making profit as long as the stock remains above $15.
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