There’s no free lunch in the market…but is there?
“There ain’t no such thing as a free lunch.” This old adage refers to the idea that it is impossible for anyone to get something for nothing. Even if something is free, someone somewhere is paying for it. However, investors have the choice to either accept a price or not, that is why we have limit orders. Imagine if everyone had the same risk tolerance and expectations; then there would not even be a market. In the market, every investor has a unique combination of risk tolerance and expectations. The ultimate goal is to get the highest return for the least amount of risk. So let’s cut to the chase and talk about opportunity cost and what dollar amount would make you click on the trade button. In the world of options, you are given rights, but they come at a cost. And if you are the option writer, what kind of payoff are you comfortable with?
| Call buyers | Call writers |
|---|---|
| For call options, you need to pay the price of the option to have the right to buy the underlying stock at the strike price before expiry. | If you are the one receiving the premium from the call buyer, then you are on the hook to deliver the underlying shares, if you get assigned. |
No one likes to be obliged to do anything. Being forced to deliver shares might sound especially awful, but what if you are happy to do it? What if you can profit from this trade? It sounds better now, right? Let me show you an option strategy where you get paid upfront to potentially sell your shares. This might seem like a free lunch, but as we said above, there is no such thing. This strategy is called covered call writing.
Here’s an example of how a covered call strategy works:
Step 1: Buy 200 shares of ABC Inc. for $20/share.
| Step 2: Look at the option chain and write 2 x $22 calls for $0.60/share. | Call | Bid | Ask |
| 3-mth $18 strike | $2.50 | $2.60 | |
| 3-mth $20 strike | $1.35 | $1.45 | |
| 3-mth $22 strike | $0.60 | $0.70 |
Step 3: Here is how a covered call will appear in your trading account:
| Quantity | Position | Price | Amount | Tip: Use the strike price at which you are willing to sell your shares. |
| -2 | ABC 3-mth $22 call | $0.60 | $120 credit | |
| 200 | ABC stock | $20 | $4,000 debit |
There you go, you just made $120 over a 3-month period on 200 shares (2 x 100 x $0.60 = $120). By writing the calls, you made a 3% premium return ($0.6÷$20) right off the bat. This is 12% on an annualized basis. This looks great, so you can treat yourself to a nice meal, right? Not so fast. Let’s take a look at the implications.
Covered: The term “covered” in “covered call writing” comes from the fact that you are using shares you own to cover your obligation to deliver the stock in the event that you get assigned.
Step 4: Potential outcomes in 3 months’ time:
| #1 ABC Inc. < $19 | #2 ABC Inc. stayed at $20 | #3 ABC Inc. > $22 |
Sometimes bad trades will happen.
|
The stock was a dud and didn’t move.
|
The call buyer is going to exercise the call and buy the shares from you for $22 (the strike). You are assigned. But don’t despair. Take a closer look, you achieved 2 goals here:
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So now you understand the covered call strategy. After reading the three scenarios above, who got the free lunch after all? Bon appétit!
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
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