Understanding A Covered Call Strategy
The other day, I wrote about how people are piling into funds, then employ option premium-selling strategies, particularly covered calls or buy-writes.
I figure it’s a good time to drill down into exactly what these strategies entail and highlight both the pros and cons.
The covered call strategy is one of the most popular options strategies especially among investors that don’t consider themselves ‘options traders’.
It’s a way for owners, especially for buy and hold types, to generate income from the stocks they own while also providing a bit of a hedge for their portfolio.
But, for those that might not want or don’t have the funds to own a lot of shares in many different names, there is an option strategy that replicates a covered call but is much more capital-efficient and therefore, can deliver much higher rates of return. It is called a diagonal spread.
I will indeed take a deep dive on the diagonal spread but for now, let’s drill down into a covered call.
When a trader writes a covered call, usually they are looking to sell theta decay, a component of premium. They often will not consciously understand that, but when quizzed, that is generally their objective. Selling premium can mean many things. But, in this writing, we mean selling extrinsic value.
Extrinsic value is the component of an option price most influenced by time passing by, as the underlying symbol price changes, and also the buying and selling pressures of the option itself. Intrinsic value, the other component of an option price, is that the actual value of the option at expiration; the real tangible value. The intrinsic value is only a function of the underlying symbol price and the option type (call or put). The intrinsic value of an at-the-money or out-of-the-money option is zero.
Near term, premium is what is most often sold. Here is a graph showing how the value of premium is not linear with time. An option will lose much less value over a day passing when it is 60 days from expiring than when it is five days. The risk with covered call writing is that the underlying symbol will appreciate, causing the buyer of the option to exercise it, or worse, depreciate, leaving the seller with a premium against a devalued underlying symbol. Selling near-term premium optimizes the highest selling price with the least amount of time to wait for that price to decay. Our intention is to buy our call option back at a much lower price or let it expire worthless.
The intention is to sell multiple cycles of premium against the underlying symbol. One reason is the amount of research and familiarity that goes into picking an underlying symbol is long and arduous. It is not something a trader wants to spend their time doing often. Once you find an underlying symbol to write premium against, you would like to stick with it for a while. Another reason is simply the calculation of return on invested capital.
Every cycle you sell premium against an underlying, and it expires worthless, lowers your investment. The profit of the previous cycle is subtracted from your investment. The profit of the current cycle over the lowered investment exponentially increases your return on invested capital. Each subsequent cycle, you have profit on a lowered investment. It is not linear. Let that sit for a moment.
I sell a monthly premium. There’s ample liquidity in the monthly options. On average, I am in a covered call for four to five months (four to five cycles). My record is 14 months, 14 cycles. On that trade, my initial investment was reduced to zero.
Creating a free position means there is no longer a downside, which makes it a whole lot easier to take a multi-year long term outlook for much larger profits.
Note: This article originally appeared at The Option Sensei.
Category: Options Trading
