What is covered call writing?

A covered call strategy consists of an investor selling a call option on a stock that they own. While this may sound complex, covered call strategies are quite simple and suitable for some beginner options investors.

A covered call writing strategy offers the investor a form of hedging against downside risk. Essentially, the strategy implies the investor is selling some of the stock’s potential gains in exchange for the premium received from the option.

Let’s jump straight into an example to see how this strategy can benefit investors.

Shares of Blackberry (TSX: BB) are trading at $7.99 per share (as of August 23, 2022) while the October 2022 $10 call options contract trades at $1.65.

Selling the call options implies the investor collects $165 in cash per contract. But this also means they are obligated to deliver 100 shares of the stock at $10 anytime between the time the calls were written and the expiration date.

The benefits of this trade are three-fold:

1. In most cases, investors can monetize an existing asset by receiving the option premium that is taxed as if it were a capital gain. Always validate with a tax professional if this applies to your particular situation.
2. Reducing downside risk by lowering the overall cost of owning the shares.
3. Establish a price to sell the shares.

Drawbacks of a covered call writing strategy is that the investor could be sacrificing potential gains, especially if a stock performs exceptionally well.

The strategy

One of the more commonly used strategies involves the “rollover effect.” In this scenario, investors sell short term (i.e one month) call options and roll the position forward before the option expires. This allows for compounding of monthly returns and can generate substantial additional income if done carefully and consistently.

As stock volatility increases so does the option premium. If investors are comfortable with the higher volatility, they will see it reflected in the higher option premiums.Investors can write at-the-money near month calls where the time value erodes at a fast pace. Then, they will wait for the stock to be called away.

Sounds too good to be true? In a way, it is. This strategy is not ideal for a strong bull market and when the general market sentiment is bearish, investors are unlikely to find success. As such, a covered call writing strategy shouldn’t be utilized by itself, rather as part of a broader and diversified portfolio.

Benefits of covered call writing

Moving on, let’s explore three common strategies used in covered call writing.

First, covered call writing is an ideal method that dividend-focused investors use to generate additional yield from the call premiums. Since dividend investors prioritize income generation, covered call options are a great tool to use.

Investors can even take advantage of advanced covered call writing strategies like acquiring a dividend paying stock one day before the ex-dividend date (i.e. the deadline for when an investor is entitled to a cash dividend) and writing an equal number of in-the-money call options.

The next day, the investor should look to exit the stock (at a loss equal to the dividend payment) and buy back the call position at a small gain. The loss from the shares and profit from the options should cancel each other out for a net zero trade. But, the investor is entitled to the dividend payment so the overall strategy should be profitable.

Second, options have a time limit so by default it will decay as each day passes. Covered call writers take advantage of this fact as the value of the stock can remain unchanged yet the value of the option sold moves lower which benefits the seller.

Third, a great benefit of covered call writing is that the investor is paid in advance to set a selling price on the shares they hold. This is best demonstrated using an example:

Suppose an investor buys a stock at $49.40 and  sells a $50 Call option for $0.90. The call option is assigned, the investor is now obligated to sell their stock at $50. But guess what? The investor was looking to exit their position regardless at $50 so the covered call option helped generate additional income.

Covered call writing ranks among the easier to understand option strategies that even novice investors can implement. But like any other financial strategy, investors need to properly do their homework and fully understand what sort of position they are getting themselves into.

Like any other financial strategy that involves risk, investors expose themselves to potential losses. The key to minimize losses is to enter a trade with a prudent risk management plan in place. This includes a potential exit strategy if the trade moves in the wrong direction while avoiding adding more money to a bad trade.