The Value Line Daily Options Survey

Spotlight on Covered Call Writing

Reprinted from "The Value Line Guide to Option Strategies" (April 10, 2008). This new guide is available in our Subscriber Guides which Value Line makes available to the investing public.

Covered Calls

Because they involve both long stock and short call positions, covered calls are a bit more complicated than stocks alone or even simple "naked" option trades. In this chapter, we present some spreadsheet examples that can help you understand and analyze covered calls. The return and breakeven analysis in these spreadsheets are the same as we use in our twice-daily online covered call evaluations. In Chapter 9, we will show how to use the analysis in managing your covered call portfolio.

In-,At- & Out-of-the-Money

You create a covered call when you buy or own a stock and write a call on this stock. In effect, you collect a premium in return for giving up some potential gains in the stock. This is because if the stock ends up above the call's strike price, your short call will be exercised and you will be required to sell your stock at the strike price - or, if you want to keep the stock, you will have to buy the call back. Understand that when you write a covered call, you are basically bullish; you want the stock to end up at or above the strike price. At the same time, however, you believe you are amply compensated by the call premium for selling off the possible gains above the strike price.

In Table 13 below, we show three examples of writing a January covered call on United Therapeutics with the stock at $100. In the top part, we have written an out-of-the-money $110 strike covered call at $2.30. In the middle, we have written the at-the-money $100 strike covered call at $6.10. In the bottom part, we have written the in-the-money $90 strike covered call at $12.50.

In all these examples, we show the results as if we are keeping the stock at expiration and buying the call back if it is in-the-money. Letting the stock be called away at expiration at the strike price would give you the same set of outcomes.

Let us look at the out-of-the-money covered call first. Here we get to keep the entire premium as long as the stock ends up below this $110 strike price. This is an excellent strategy for investors who want to be long the stock but also want extra income. Notice that below $110, you have a clear profit of $230 on your short call. Above $110, you will have to buy the call back at its tangible value (or you have to let the call get exercised); however, you will still have that original $230 premium. At expiration, the stock would have to be above $112.30 for the stock position alone to have done better than the covered call.

Next, we look at the at-the-money covered call, a position in which we are moderately bullish on the stock and like the income from the premium. Here we take in $6.10 per share or $610 on one covered call. Although you can only keep this entire premium if the stock ends up at or below $100, the stock would have to rise to above $106.10 for the covered call to under perform just owning the stock. If the stock stays unchanged at $100, you still keep the premium. The stock would have to fall below $93.90 before we would lose money on this trade.

Lastly, let us look at the in-the-money covered call, selling the $90 strike call for $12.50. In this example, we are only moderately bullish, and are willing to take a highly protected position which pays an attractive net income but also offers a breakeven point well below the current stock price. As long as the stock ends up above the $90 strike price, we net out with a $250 profit. This profit represents the time premium on the call that we just wrote (i.e. $12.50 minus the call's tangible value of $10.00).

Calculating the Percentages

In Table 14 below, we show how you can calculate the various risk and return percentages on covered calls. We make a spreadsheet version of this file available in our Excel Software directory (filename Ccalc.xls). We also use these formulas in our twice-daily updates on options. All these covered calls are reasonably attractive but offer different combinations of maximum profit, downside protection and annual return on the premium.

Take a look at the out-of-the-money $110 strike covered call. Here you see that the maximum profit is equal to 12.59%. This is based on the fact that it costs you $97.70 per share to establish the position ($100 - $2.30) and you get a maximum payoff of $110 per share. If the stock stands still, you get a return of $2.30 (based on paying $97.70 to establish the position and getting $100 at expiration). Multiplying this number by the 365 over the number of days gives you an annualized return of 14.09%. Your downside protection is predicated on the fact that you paid only $97.70 to establish the position so the stock could fall to the level before you would lose money.

With the at-the-money covered call, your maximum profit of $6.50 is based on your having to pay $93.90 to establish the position and getting $100 at expiration as long as the stock ends up above the $100 strike price. This is also your return if there is no change in the common and your annualized return is a hefty 38.87%. Your downside protection is 6.10%.

The $90 strike in-the-money with a premium of $12.50 covered call consists of both tangible value of $10 ($100 - $90) and the $2.50 time premium. By writing the call against your stock, you effectively have to give up your stock at the $90 strike price as long as the stock ends up above $90; however, you only had to pay $87.50 to establish the position (i.e. your cost basis). On an annualized basis, your return works out to be 17.10%. Since, the stock would have to fall to $87.50 before you would lose money, your downside protection is equal to $12.50 or 12.50% of $100.

A Word on Dividends and Early Exercise

The stock we chose to display, United Therapeutics, pays no dividend. However, if there is a dividend, we have to incorporate that into our return and breakeven calculations. Investors who write covered calls on dividend paying stocks need to be aware that they can run the risk of having the stock called away if the call is in-the-money and there is an "ex-dividend" date before the expiration. This ex-dividend date is the day the company establishes the holder of record to whom the dividend gets paid. Therefore, before you write a covered call on a dividend paying stock, you should check if there is an ex-dividend date before the expiration of the short call.

Prepared by Lawrence D. Cavanagh
vloptions@valueline.com