Covered Calls

You know that old Sega Dreamcast you've got lying around collecting dust? You don't want to get rid of it, the arcade conversion of Daytona, Virtua Cop, and Sega Rally were incredible and you still enjoy the occassional game. Plus it'll probably be worth something some day as a collector's item. Wouldn't it be great if you could loan it out and make a few bucks while you're not using it?

Obviously you can, just go do it. Maybe it's not a Dreamcast, maybe there is something else you want to keep but also wouldn't mind making a few dollars on in the short-term. A dress? Your car?

This simplistic leasing analogy is how I still think about call options.

First, defining terms…

When someone "writes" an option, it's just another way of saying they're selling it. And being on the selling side of an option means you're making an obligation to someone else. Our little lesson on rights & obligations taught us that being on the obligation side of an option can create unlimited levels of risk! Terrifying! Why on earth am I starting with this?!

A call option is is giving the option buyer the right to buy stock at a pre-determined price. That means as the person selling the option you can manage your risk by buying the stock. And that's where the "covered" bit comes in. If you're writing/selling a "Covered Call" you have all your risk covered because you already own enough stock to meet your side of the obligation.

Back to bad analogies, with examples

Say I'm lucky enough to own 1,000 shares of AAPL stock (currently trading at $435), and while I am positive about the long-term prospects of the company I think the media has gone a bit crazy lately. If anything it's over-hyped, and probably going to be stuck where it is or drop a little bit. I've no plans to sell, but wouldn't it be nice to make a little extra cash? Especially given the current mass hysteria, clearly everyone else is a bit more excited about AAPL stock than I am.

So let's write a call option! Each single option gives the buyer the right, but not the obligation, to buy 100 APPL shares off us at a pre-determined price, and at a pre-determined date. It's currently June, AAPL is at $435, and we think it's going to be stuck in a rut for months. Let's say until November. Looking at the AAPL options that expire on the 19th October 2013, there are a few that have "strike prices" just above the current price:

  • $440.00 at $24.10
  • $445.00 at $21.90
  • $450.00 at $19.90

But what does that even mean?!

Gah, more terms!

So in the list above we have 3 "strike prices" ($440, $445, and $450). This is the pre-determined price at which the buyer of the option can buy our AAPL stock on the 19th of October. The 19th of October is the "expiry date", it's the last day on which the buyer of the option can exercise their right to purchase. On the 20th of October that right expires, and the contract is worthless.

The other number there is referred to as the "option premium" ($24.10, $21.90, and $19.90). This is the price the buyer has to pay for each option contract. That price is determined by taking a number of factors into consideration (e.g., the current price of AAPL shares, how many days until the expiry date, the volatility of the stock price) and is worthy of a topic all by itself. So I'll cover that in-depth separately. For now it's sufficient to know it's a reflection of the odds of the stock being at that price on the expiry date, the more likely it is the higher the premium.

Show me the money already

If we're really confident the stock is going to stay flat or drop over the next 5–6 months, then we'd take write 10 option contracts at the $440.00 strike price for the 19th of October expiry. 10 option contracts because we've 1,000 shares to cover this with (and each option give the right to buy 100 shares, so 1,000/100 = 10). 10 contracts at $24.10 gives us an extra $241.00 in cash (minus any brokerage or fees we have to pay). Nice!

Free money? No risk?

I never said that. Writing a "covered" call by owning the shares only minimises our risk, it doesn't remove it entirely. So what's our risk here? Well the risk is we got it entirely wrong, AAPL suprise announce a new iPhone and their stock races back up to $600. But we own AAPL stock, isn't their price going up a great thing? Not any more, because now the most we can hope to make on AAPL between today and the 20th of October is $440. All that extra money between $440 and $600, that goes to the person who bought the option (and most likely your shares) off you.

Don't be foolish, but also don't be greedy. Be conscious of the fact that writing a covered call does expose you to the risk that you might have to sell your stock. So make sure the strike price you choose is one that you'd be happy to sell your shares at. And then don't lament that fact that you missed out on some extra money, be happy with the cash you did make and move on.