8/21/08

Traditional Covered Call Writing vs LEAP "Covered" Call Writing

Writing Calls

Selling (writing) covered calls is one of the most conservative options strategies. I've talked about puts before, if you're interested. For those unfamiliar, a call is a contract on an underlying asset (like 100 shares of stock, a painting, car, house, etc) that gives the buyer of the contract a right, but not an obligation, to buy the asset at a certain price within a certain time. In exchange for this right the call buyer pays the call writer a premium.

There are two types of call contracts, covered and naked. A call is covered when the call writer owns the underlying asset. A call is naked when the call writer does not own the underlying asset.

Let's take a simple example. Suppose I have a painting, with a cost basis of $10,000. I decide that I'm willing to part with it for $12,000. I meet an interested buyer, Bob, but he's not sure he wants to pay that much. He wants some time to think about it. Fearing that another buyer may emerge or the price of the painting will appreciate while he's thinking about it, he offers to pay me $500 to give him the right to buy the painting from me for $12,000 within the next year. This is a covered call contract. I am the writer and Bob is the buyer.

There are several possible outcomes. Here are a couple. Suppose a few months after the contract is signed the painting's value appreciates greatly for whatever reason. Say its market price is now $20,000. Bob can now exercise his right and purchase the painting from me for $12,000. My profit would be $2,500 ($500 premium Bob previously paid plus the difference of the selling price and my cost basis). Bob would make a $7,500 profit (painting's current market price less the premium he paid me, less the sell price). Bob has another choice. Suppose he's merely a speculator with no interest in art. He can sell the contract to someone else, and that person can buy the painting from me for $12,000. My gain would be the same ($2,500). Bob's gain would be however much he sold the contract for less the premium he paid me. The third party's gain (or loss) would be the painting's current market value minus the sum of the premium they paid Bob and the $12,000 selling price.

Why Buy and Sell Calls?

The appeal of buying calls is readily manifest. If the underlying asset goes up in value within the time period specified in the contract, the call buyer can get great returns on a relatively small amount of capital. In the example above, Bob has made a $7,500 profit on a $500 investment. Should the asset fall in value, the call buyer doesn't have to buy it. His maximum loss is the premium he pays for the call. The owner of the underlying asset, on the other hand, can lose however much he originally paid for the asset.

Writing covered calls can also be appealing. It puts cash into the writer's pocket right away. If the contract expires without being exercised, the premium received is the call writer's profit. With regard to stock options, covered call writing can be a great way to generate extra income from your stock holdings.

For example, let's say you bought 100 shares of Verizon (VZ) at $32 a share. As I'm writing, Verizon is trading at $34.50. You can sell right now and make a $250 profit. But suppose you want to hold the stock for as long as possible. It pays a good dividend, its future looks pretty bright, etc. If you want to generate some extra "dividends" off of your position, you might consider writing calls. Suppose you think Verizon's share price will remain relatively stable between now (August 21st) and mid October. You don't think the share price will reach $37.50, but you're willing to part with the stock at that price. As I'm writing, the October '08 37.5 call is trading at 0.42 (or $42 a contract, as each option contract, usually, is for 100 shares).

Let's say you go ahead and sell the October '08 37.5 call. Right away, you pocket $42 (I'm ignoring commissions). In exchange, you've given the call buyer the right to purchase your 100 shares from you for $37.50 a share between now and October 18, 2008. If Verizon's share price at the contract's expiration is at or above the 37.5 strike price, your stock will be sold. Should this occur, your profit will be $592 ($3,750 selling price plus $42 premium received less your original cost basis of $3,200). If Verizon's share price does not reach $37.50 a share before October 18, chances are the contract will expire without being exercised. You'll get to keep your shares. Your profit will be the premium you received (note that if VZ's share price plunges during the period, say to $25 a share, you will have a paper loss of $700, which would be slightly offset by the $42 premium you received).

Writing Covered Calls Safer than Writing Naked Calls

Writing covered calls is considered a conservative strategy because you own the underlying asset. If the option is exercised, you simply sell the buyer your shares.

You may have surmised that naked calls can be much more dangerous. When you sell a call on a stock you don't have, you receive the same premium as the covered call writer. One advantage of naked call writing is that if the underlying stock plunges, you don't even suffer a paper loss. The danger, however, comes from the underlying stock going up in price. Suppose you sell the Verizon October '08 37.5 call for a premium of $42, as in the example above, but you don't own 100 shares of Verizon stock. Should VZ's share price go above $37.50 before the contract expires you may lose a lot of money. If the buyer exercises the contract, you have to deliver 100 Verizon shares that you don't currently own. You have to buy them on the open market. (Note that to avoid option assignment when the underlying stock's share price approaches the strike price, you can buy back the call--probably at a higher price--before it is exercised.) Suppose VZ is trading at $45 a share. You spend $4,500 buying the hundred shares. They are then delivered to the call buyer, and he pays you $3,750 for them. You've lost $708 ($750 loss offset by $42 premium previously received).

With a covered call, the most you can lose is your original cost basis on the underlying stock less the premium you receive for the call. With the writing of naked calls your loses are theoretically unlimited. Naked call writing is thus not for everyone. Brokerage houses often make you meet various requirements (in terms of your cash balance, salary, and trading experience) before they let you sell naked calls.

Disadvantage of Covered Call Writing

For the conservative investor looking to generate more income, covered calls are the way to go. One major disadvantage of covered call writing, however, has already been alluded to. After you have sold the call, you are sort of stuck with the stock until the contract expires or is assigned. In most cases, you have to buy back your call before your broker will let you sell your shares. Because near term option premiums are rather small, they hardly offset large drops in share prices.

Suppose, as above, you sell an October '08 37.5 call on your 100 Verizon shares. Recall that in the example your cost basis is $32 a share. Let's say there's some terrible news, a panic ensues, and over the course of the month VZ drops to $16 a share. Let's say you didn't sell your shares earlier in the drop because you thought they'd go back up (dropping stocks often have big rallies before falling further--look at a chart of FRE and FNM since January). Having to buy back the call also weighed on you. Well, as a result you've suffered a paper loss of $1,600, offset slightly by the $42 premium you received.

LEAP "Covered" Call Writing vs Traditional Covered Call Writing

Such a loss could have been minimized with a little less conservative "covered" call writing strategy. Instead of owning 100 shares of the underlying stock, you can own a LEAP call with a lower strike price. A LEAP call is a call contract with an expiration date longer than a year in the future.

Suppose that instead of buying 100 shares of Verizon for $32 a share, you buy instead one January '10 20 call for 12.42 (for a purchase price of $1,242). Between now and January 16, 2010, you get to control 100 shares of Verizon. You have the right to buy 100 shares of Verizon for $2,000. (Should you exercise this right, your total purchase price will be $3,242.) Rather than paying $3,200 for the shares, you spend less than half on the LEAP call.

As in the previous example, suppose you write the October '08 37.5 call, pocketing the $42 premium. The goal, if you recall, is to generate income without having to sell the underlying stock. If Verizon doesn't reach the 37.50 strike price, the option will probably expire without being assigned. At that point you can go ahead and write another call. In the covered call write, you would have generated the $42 on a base of $3,200. If you own the LEAP call instead, you're generating the $42 on a base of $1,242. If you own the underlying shares your yield is 1.31%. If you own the LEAP instead, your yield is 3.38%. Selling four covered calls a year for about this premium would get you a yield of around 5.25%. Doing the same with the LEAP call as your underlying, would get you a yield of around 13.5%. (Should you decide to take on some more risk, you can buy two LEAP calls for less than the cost of 100 shares. Selling eight similarly priced covered calls a year would get you the same 13.5% yield, but twice the income). Note that the actual income generated on owning Verizon shares would be higher than 5.25%, given that you'd be entitled to Verizon's regular quarterly dividend payments.

But suppose that within the contract period the stock goes to $45 a share and the buyer exercises it. Had you written a naked call (not owning 100 shares) we saw above that you would lose $708. Not so if you own the LEAP call. After buying 100 shares for $4,500 and selling them to the call buyer for $3,750, you can exercise your LEAP call. You'll pay $2,000 for 100 shares of Verizon. You can then sell these for $45 a share. The net result is a gain of $550. ($1,242 LEAP premium plus $2,000 = $3,242, your cost basis for the new shares. You sell these for current market price of $4,500. This results in a profit of $1,258, which is decreased by the $708 loss from your call write assignment. This comes to a profit of $550. Another way to do this, with the same net result, involves short selling the 100 Verizon shares to be delivered to the buyer of the October call and then exercising your LEAP call.) This is slightly less than the profit of $592 you'd receive had you purchased 100 shares of Verizon at $32 instead of buying a LEAP call. Remember, though, the original goal was to generate income. Using the LEAP call originally involved less than half the capital to accomplish the same task.

Let's say the opposite of the above scenario happens. Instead of VZ going up and being assigned, the stock plunges to $16 within a month. If you owned 100 shares (with the cost basis of $3,200, as in the examples above) you would suffer a paper loss of $1,600 offset by the $42 premium you received for writing the October '08 call. That's a paper loss of $1,558.

With the LEAP call as you underlying, on the other hand, the most you can lose is how much you paid: $1,242. If VZ got a 50% haircut in less than a month, volatility would spike. Given that one of the factors in option pricing is volatility, and volatility has a direct relationship with an option's price, your Jan '10 20 call would be worth more than $0. So, your paper loss would be less than $1,242. Factoring in the $42 premium received for the October '08 call write, your paper loss would be less than $1,200. Compare this with the paper loss of $1,558 if you owned the shares instead. In terms of limiting losses, then, it can be better to own LEAPs instead of shares of the underlying stock.

Things to Note

Don't try the LEAP "covered" call strategy without doing further research on the subject. The above is a simplistic overview of why owning leaps instead of actual stock may be advantageous for a call writing strategy.

Owning calls does not entitle you to receive any stock dividends and does not give you any other shareholder rights.

Be sure to formulate a clear plan for your entries and exits should you ever attempt a call writing strategy with LEAPs as your underlying.

A factor in option pricing is time to expiration. For example, an October '08 option at strike x will generally be worth more than a September '08 option at the same strike price. Because of their high deltas, deep in the money LEAP options behave similarly to their underlying stocks. As the LEAP's expiration date draws closer and time decay sets in, it may not be advisable to continue writing calls on it. Consider closing the position or rolling the LEAP to an option with an expiry date farther in the future (e.g, selling the January '10 call and buying a January '11 call).


Disclosure: I don't hold a position in any securities mentioned above.