WHAT IS COVERED-CALL WRITING?
When an investor who owns stock sells call options on that stock in an amount equal to or less than the number of shares he owns, the transaction is referred to as covered-call writing. The writer of the call options receives income from the buyer, in the form of the option premium, in exchange for giving the buyer the potential appreciation in the stock above the strike price of the calls. A long term covered writing program starts with a target price for an underlying stock, on which calls are sold - and in some circumstance, bought back – until the target is reached, at which point the shares are generally called away. The strikes of calls sold in covered-writing programs tend to be higher than the current price of the underlying stock; such options are referred to as out-of-the-money. Options with strikes equal to the current price of the stock are referred to as at-the-money.
WHAT IS THE OBJECTIVE FOR A COVERED-WRITING PROGRAM?
The first objective is to lower risk (as measured by the variability of returns) by reducing the carrying cost for the stock. For example, selling a six-month at-the-money call option for $10 on a stock trading at $100 reduces the stock’s effective cost by 10 points, to $90, and thus cushions the impact of a decline in the share price. The second objective is to efficiently capture an option’s time premium – its total price minus its intrinsic value (the amount by which the current stock price exceeds the strike price). The time premium represents the amount a speculator is willing to pay for potential price appreciation in the stock and reflects the stock’s expected volatility over the life of the option. The price of an at-the-money or out-of-the-money option consists entirely of time premium.
WHAT RETURNS SHOULD ONE EXPECT FROM A COVERED-WRITING PORTFOLIO?
This strategy performs best in moderately appreciating equity markets with volatile trading ranges where investors tend to overpay for time value. Covered-writing returns should outpace those of straight equity position during such periods and will also outperform in declining or stagnant markets, because of the premiums that are captured from selling the calls. Covered-call writing may even outperform straight equity on a risk-adjusted basis in periods of high price appreciation, if the appreciation is accompanied by high volatility. During such periods, equity investors tend to act emotionally and make mistakes in timing their trades, which reduce returns. By allocating funds to a more conservative asset class, such as covered-writing program, an investor can control risk and achieve a discipline that helps avoid such mistakes.