Covered Calls: Doing the Math
Why and when should I invest in a covered call? Which covered calls are best for me? In this report, we review some helpful covered call calculations so you can make these decisions.
Why Write a Covered Call?
You create a covered call by buying (or owning) the underlying stock and writing a call on this same stock. The risk of the short call is fully covered by the stock (which can be delivered to the exchange, if the call is exercised). Consequently, a covered call has no margin requirement.
The reason you write a covered call is to collect income from the call premium and to partly protect your downside. In return for the premium you collect, you give up gains above the strike price. If the stock ends up in-the-money, then you will be forced to sell it at the strike. When you write a covered call you are assuming that the premium is overpriced compared to how much you expect the stock to move.
Our research shows that premiums become overpriced when the options market overreacts to news, rumors or to recent stock price volatility. Sometime speculators, expecting a sudden advance in a stock, will start bidding up premiums to inflated levels (often in the more highly leveraged higher strike calls). At other times, premiums will spike following surprise reversals in a stock, when holders of the stock are seeking protection from buying puts. Long-standing subscribers to The Value Line Daily Options Survey will note that when premium levels are high (usually following periods of high market volatility), our model can find a large number of overpriced calls suitable for covered call writing, and when markets are calmer, there tend to be fewer of these overpriced calls.
The Value Line Options model selects covered calls based on a combination of criteria: (1) expectations for the stock itself based on the common stock rank; and, (2) the degree to which the call is overpriced with respect to our forecast of future volatility. From the beginning of 1980 through the second quarter of 2001, our recommended covered calls returned 26.4% p.a., beating the S&P 500 more than 2/3 of the time.
Two Examples of Returns
The two examples in Table 1 were taken from our Selected Options for Covered Call Writing on May 8, 2002. They help demonstrate our model's logic and are typical of our recommended covered calls since they offer attractive but differing degrees of upside potential, return and downside protection.
The out-of-the-money September covered call on Orbital Sciences, with a strike price of $7.50, priced at $0.97, costs the investor $5.22 per share to establish (i.e. $6.19 to buy the stock minus the $0.97 premium received from writing the call). This covered call offers the investor downside protection of 15.0% based on the fact that breakeven for this position is at the $5.22 level. If the stock rises to $7.50 or above, the investor reaps a profit of 44.0% (i.e. the difference between the $7.50 strike price and the $5.22 needed to establish the position). If the stock stands still at $6.19, the investor still gets an annualized return of 57.0% over the 138-day period to the September expiration date.
The in-the-money January 2003 $5.00 covered call, priced at $2.32, offers a greater degree of downside protection since the stock would have to fall by 37.5%, to $3.87 before the investor would start to lose money. Upside potential, however, is limited by the fact that the stock price is already above the strike price. Nevertheless, if the position is held to expiration and the stock ends up at or above the $5.00 strike price, the investor will still reap a substantial return of 29.2% (before commissions), which comes to 43.9% on an annualized basis.
In Table 2, we show the formulas for the above calculations.
Searching for Covered Calls
Investors who want to look for covered call opportunities can use The Valueline Daily Options Survey's daily spreadsheet file, Calls.Csv. This Microsoft excel compatible file contains virtually all regularly listed calls (approximately 40,000) with fields of such pertinent items as percent under/overvalued, covered call rank, per annum return, downside protection and maximum profit potential. With this information and Excel's powerful and easy-to-use database capabilitities, the investor can find covered calls that meet his or her objectives.