In this article I will explain what is the covered call strategy, how the covered call works from the beginning until the end of operation and also how can you can make money with the covered call. Let’s apply the concept to the share market.
For this explanation, I will use an example from my book Gain Monthly Income with Shares . Let’s begin with an investor Ana who just bought 100 shares of Company XYZ at $50 per share, a total of $5,000. She intends to sell these shares for at least $52 each.
After a week and with good news regarding Company XYZ, Joseph another investor is interested in the same stock because he believes these shares can appreciate significantly in the next month.
How Covered Call Works
However, he is just speculating and does not want to invest a total of $5,000 to buy the 100 shares, or maybe he does not have all this value available. So he again seeks Ana for a deal. Everything is done using an online broker in real life, and people do not need to know each other.
So, Joseph and Ana enter into a contract. Ana sells an option contract to Joseph, an option known as “ call”, which gives the buyer of the option the right but not the obligation to buy the shares at the agreed or chosen price. They agree on the shares sales price of $52 and the value of $2 per option, with each option equivalent to one share.
As there are 100 shares, the option contract’s value is $200, as it refers to 100 options underlying the 100 shares. The exercise price or strike price is $52; this is the price that Ana wants to sell the shares anyway, with an expiration of one month.
In this contract, Joseph has one month to decide whether or not to exercise the option (his right) to buy the 100 shares at the asking price of $52 per share. The following are the terms of the contract;
XYZ Stock: 1 Option Contract – Equivalent to 100 shares
Premium or Deposit: $200 (unit value $2 x100)
Contract Duration: 1 month
Selling price / Exercise Right: $52 per share (100 shares $5,200)
In addition to Ana, other investors also bought 100 shares of XYZ company for $50 each share, a total investment of $5,000, but they are not interested in options contracts.
Let’s imagine three possible outcomes after a month. Joseph has until the end of the 30 days to decide whether to buy the shares or not.
No matter what Joseph’s decision is, in any of the scenarios, Ana will receive and keep the premium of $200.
❖ Scenario 1 (after 30 days) – Shares depreciate
❖ Scenario 2 (after 30 days) – Shares stagnate
❖ Scenario 3 (after 30 days) – Shares appreciate
Which Covered Call to Sell
The next examples will help us when to choose the strike of call option that we want to sell.
Scenario 1 – Shares depreciate in price
In this scenario, the company performs poorly, and the shares depreciate from $50 to $48. As a result, the total amount of equity invested in the 100 shares falls to $4,800.
Shares – Market Value: $4,800
Right to buy: Joseph does not exercise the right to buy at $52 per share
Joseph: Loses the total amount invested, premium of $200
Ana: Retains her shares, now at $4,800 and the premium of $200
Other investors: Retains their shares, now at $4,800
In this scenario, Joseph does not exercise the right to buy the shares for $52 because he can go to the market and pay the current lower price, $48 per share. He then loses the premium of $200, and the option expires without value.
Ana saw her investment depreciate to $4,800, but as she gets the premium of $200, she can thus keep her equity in the total amount of $5,000. In addition, she achieved a yield of 4% in one month or 48% annualized.
The return calculation is the premium of $200 divided by the initial investment of $5,000 and then multiplied by 100 to find the percentage.
Now that 30 days have passed, Ana can sell another option in the following month and generate a regular income.
She is in a much better situation than the other investors, who did not use options and saw their equity depreciate from $5,000 to $4,800 in this example.
Scenario 2 – Shares stagnate
In this scenario, nothing interesting happened in the market; XYZ’s stock price did not move much and closed at $51, an appreciation of $1 per share at the end of the 30 days.
Shares – Market Value: $5,100
Right to buy: Joseph does not exercise the right to buy at $52 per share
Joseph: Loses the total amount invested, the premium of $200
Ana: Retains her shares, now at $5,100 and the premium of $200
Other investors: Retains their shares, now at $5,100
In this scenario, Joseph again does not exercise the right to buy the shares for $52 because he can go to the market and pay less, the current price of $51 per share.
The slight appreciation of the stock from $50 to $51 was not enough. So again, he loses the premium of $200, and the option expires without value.
However, Ana keeps both the shares worth $51 each, a total value of $5,100, and the premium received of $200, obtaining again a return of 4% in a month or 48% per year.
Her total equity is now worth $5,300, and she can sell another option on the market. What if she did this every month? Remember, the equity of other investors increased to $5,100 without any additional income.
Scenario 3 – Shares appreciate
Joseph was correct in his forecast, and XYZ’s share values reach $56 per share in this scenario.
Shares – Market Value: $5,600
Right to buy: Joseph exercises his right to buy at $52 per share. Ana is assigned and has to sell the shares to Joseph for $52.
Joseph:
Buy the shares for $5,200
Sell the shares on the market for the current price of $5,600
Gain $400
(-) $200 premium
Profit: $200
Ana:
Initially bought the shares for $5,000
Now sell them for $5,200
Gain $200
(+) $200 premium
Profit: $400
Other investors:
Initially bought the shares for $5,000
They now sell them at the market price of $5,600
Profit: $600
Thus, Joseph will exercise the option, his right to buy, and Ana will receive an assignment note. It means she has been assigned and must sell her shares for the unit value of $52 to Joseph, even though the stock’s current market value is $56, because this is her obligation, according to the contract terms.
Joseph will then buy each share for $52, and he can sell the shares on the market at $56, making a profit of $4 per share, for a gain of $400 in this transaction. However, it is still necessary to subtract the amount of $200 that Joseph paid for the options contract, thus leaving him a profit of $200.
Ana initially bought the 100 shares for the unit value of $50 and now sold them to Joseph for $52, which generates a profit of $2 per share, a total of $200 and, with the additional $200 of the option premium paid by Joseph, she obtained a total profit of $400.
The other investors bought the 100 shares at $50 each and sold for $56 without using the options market. In this scenario, the other investors had a total profit of $600, higher than Ana’s total profit of $400.
Is Covered Call Worth
As they say, in the financial market, there is no such thing as a free lunch. To win something, you have to give up something else. Ana did not enjoy the high appreciation of the shares in this scenario to obtain a constant and regular income.
The book cover the best scenarios for implementing this strategy.
Note that despite having a lower return this time, Ana maintained a positive balance in all three scenarios. That’s the great message I intend to send with this book. As I said earlier, the market has three directions: up, down, or stagnant. The covered call vendor benefits from all scenarios.
It is worth remembering again that, in this strategy, the risk is always in the asset (the share or land, as in the previous example) if it depreciates too much. There is no added risk with the sale of the option if the investors already own the shares.
Important note: Selling the call without having the stock in the portfolio is a high-risk strategy. This is called naked call selling and is not recommended in this book.