Covered call writing is generally thought of as a conservative option writing approach because the call options that are sold for the premium are not naked. Covered call writing involves owning the underlying - which may be stock or futures contracts - and selling the call options against that underlying position.
Should the covered call option get in the money with a rise of the underlying, the worst that can occur is that the stock position gets called away. In such a scenario, the investor still gains because the premium is retained as profit while the stock position rises to the strike price of the covered call option, the point at which the writer would be assigned during an exercise.
Covered call writing is typically done if the investor maintains a neutral to bullish outlook and plans to hold the underlying long-term. Since the calls sold are 'covered' through ownership of the underlying, there is no upside risk in selling (shorting) calls. However, the problem arises on the downside, where a large unexpected drop of the underlying can result in large losses, as the call premium collected in a typical covered call write affords an investor very limited protection.
Since stocks can drop quite far quite quickly, the small amount of call premium collected in most covered-call writes is very little for hedging downside risk. Fortunately, there is an alternative if you want to reduce downside risk but still collect call premium with covered writes and have upside profit potential.
I have worked out a covered call writing approach that offers the potential for improved overall performance. I call it the "surrogate covered call write", and it uses stock option LEAPS instead of stock as the underlying.
The Traditional Covered Call Write
Let me demonstrate my surrogate strategy by first illustrating a traditional covered call write on J.P. Morgan (JPM). On Dec 16, 2003, JPM closed at 35.72. If I were to remain bullish on JPM, I might want to apply a traditional covered write, which has some room to profit from more upside. Let's compare the two ways we could apply the covered write: the traditional approach involving ownership of the underlying and my alternative plan using LEAP as surrogate.
First, let's set up the traditional write. If we want to do a six-month covered call write, we could sell the just out of the money Jul 2004 37.50 call, which is currently selling for $1.60 (or $160 for one option, which is covered by 100 shares of stock owned, which is the assumed position size for both our examples). If JPM closed on expiration day Jul 17, 2004 at the strike price of the 37.50 call (the maximum profit point), we would make [$1.78] per share, plus we would keep the $1.60 as profit for the call option, which would have expired worthless. Maximum profit is thus [$3.38] per share, or [$338], as seen in table 1. There would be an additional small gain from any dividends earned during this six-month period, which is not factored into this case.
|JPM Price||July Call Strike||Call Premium||Maximum Profit|
Table 1 - Traditional Covered Call Write (prices from close of trading December 16, 2003).
Substituting a LEAP Option for the Underlying
For my alternative writing approach, I will, instead of buying JPM, purchase a Jan 2006 in-the-money LEAP call option with a strike price of 25, which is selling for $10.70. In other words, instead of owning J.P. Morgan, I will own a two-year call option LEAP - a long term option that trades on the underlying (and acts as a surrogate for owning the underlying) and expires on Jan 22, 2006.
Ideally, this strategy works in a mature bullish market, which is usually accompanied by low implied and statistical volatility. We want a low volatility environment because LEAPs have a high vega, which means they can increase in value when volatility increases, or fall in value if volatility declines, a point to which I will return below. LEAPs, otherwise, have the same basic pricing fundamentals and specifications as regular options on stocks.
This price represents intrinsic value only (i.e. no time value) because the LEAP is so far in the money. Since there is no time value on this option, and delta is at or very near 1.00, owning the LEAP acts as a surrogate to owning the underlying, but ties up considerably less capital. I will now sell the same Jul 2004 37.5 call for $1.60 against this LEAP. If JPM closes Jul 17, 2004 on expiration day at the strike price of the July 37.5 call, we are at the maximum profit point of [$338], equaling the maximum profit of the previous example but requiring less upfront capital. Therefore, there is greater return on required capital. (I am abstracting from transaction costs in both examples.)
|Jan 2006 25 LEAP Price||July 37.50 Call Price||Call Premium||Maximum Profit|
|Table 2 – LEAP-Based Covered Call Write (prices from close of trading December 16, 2003).|
The LEAP ties up just $1,070 (minus the premium received), which is considerably less than the $3,572 (minus the premium received) in the traditional covered call write. If we establish a long position in the underlying for less than one-third the required capital for a traditional covered call write, it would make sense to convert to a LEAP-based strategy simply on this basis - although, dividends would ultimately have to be factored in to create a fair comparison. However, the downside risk story is substantially altered, which is the more important issue.
Maximum Downside-Risk Reduction
Let's say that at expiration, JPM closes at 30 instead of at the maximum profit point assumed above. Table 3 below summarizes the losses for both covered call positions. As you can see, the traditional covered call write loses $572 on the stock position ([$35.72 - $30] x 100 shares = $572). This loss is offset partially by the profit on the expired-worthless July call, leaving a net loss of $412 ($572 - $160 = $412).
For our LEAP-covered write, meanwhile, the position would show the same loss amount, since the delta on the LEAP mimics the long stock position when in the money. Since the January 2006 call has a strike price of 25, it is still in the money at 30. It would have, therefore, lost $412 ($572 - $160 = $412). However, should the stock fall lower, the advantage shifts to the LEAP strategy.
For example, should the close at expiration of JPM be at 25, the loss on the traditional write would be $1,000 larger at $1,412, but the LEAP-covered write can lose a maximum of only $10.70 minus $160, or $910. It would also actually show a lower loss at 25 due to remaining time value on the LEAP, which would be about $150.00, and the impact of volatility which we have not examined yet. This is where it gets more interesting as an alternative strategy.
|Traditional Covered Call Write Loss||LEAP-Based Covered Call Write Loss||LEAP-Based Strategy Loss w/ Volatility Edge|
|Table 3 – Loss comparison if JPM falls to 25 (we are assuming no time-value decay in this scenario).|
Therefore, at a share price of 25 upon expiration of July 37.50 calls, if we assume there is approximately $150 in remaining time premium on the LEAP call, losses would be $760. That is nearly 50% less than the -$1,412 on the traditional write (see Table 3).
There are other, not-so-obvious advantages to a LEAP-based strategy.
The LEAP strategy is even more attractive when we take volatility into account. Since LEAPs have a high vega, a rise in volatility would raise levels of intrinsic (i.e. time value) on a long LEAP position, such as the one we assume for this article. At the time of this writing, JPM volatility was at a very low level - so low, in fact, that it has been this low only 2% of the time during the past six years. Therefore, the JPM volatility has a good chance of rising during the 24-month period before the LEAP expires and even before the July call expiration date, helping us out on the downside.
Since implied volatility and stock prices have an inverse relationship, a drop of any sizable magnitude would cause a spike in volatility - which we can model - and would further reduce the maximum loss on our LEAPS surrogate covered write strategy. If we suppose JPM falls to the price of 25, for example, there would be a substantial rise in volatility. The rise in volatility from 24% (current level) is hard to predict with precision, but we can make some projections based on recent price behavior. The last time JPM fell to 25 from above that level was in late 2002, and it pushed implied volatility up to 80%. Assuming even a rise to 45%, which is the three-year average level of implied volatility, we would have a rise of 26 percentage points of volatility, which would add approximately $280 in premium to the LEAP price at July expiration.
Now our loss can be recalculated to incorporate the amount we would gain from a rise in this volatility. The maximum loss now drops to just $480 from $760 - compared to $1,412 on the traditional write, that's an incredible 61% less, as seen in Table 3 above. If interest rates were to rise, the position would experience further reductions in the maximum loss, since call LEAPs rise in value when rates rise. But dividends would have to be factored in as well on the traditional covered write, which would reduce maximum losses there.
These other factors aside, it's clear the LEAP-covered call write strategy would seem to offer a better risk/reward scenario. But there is one other significant advantage that is not all that apparent at first.
In the traditional covered call write, if JPM were to fall to 25, some investors might be forced to liquidate the position for fear of losing even more. However, with the LEAP-covered call write, this fear is removed. For example, at the assumed price of 25 at expiration in July, the LEAP call has just approximately $150 in time value left, so there is no reason to sell the LEAP, especially since it still has 18 months of life.
But the traditional covered call writer still has a lot of potential downside risk in holding JPM stock longer. Theoretically, the price could fall to zero, although that would be unlikely. Now let's assume the traditional writer panics and sells his position when JPM breaks 25. But then if the stock recovers six months later and rallies back to 40 by the time the LEAP expires in 2006, we begin to see the beauty of the LEAP covered write strategy. The LEAP holder, who had only an additional $150 to risk when JPM was at 25, was able to ride out further downside, and ultimately, in this scenario managed to have the LEAP expire 15 points in the money, for a profit of $430. Together with the July call profit of $160, we get a total profit of $590.
This comparison does not address the kinds of rolling of the short calls or writing of additional short calls once July call expired. Nevertheless, the example of JPM does illuminate some key advantages of LEAP covered writing offers.
Investing BasicsPlain vanilla is a term used in investing to describe the most basic types of financial instruments.
InvestingWest Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
Options & FuturesProfessionals choose the options available to you in your plan, making your decisions easier.
Fundamental AnalysisOptions market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
EconomicsThe Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
Mutual Funds & ETFsDiscover analyses of the risks inherent to inverse exchange-traded funds (ETFs) that investors must understand before considering an investment in this type of ETF.
Mutual Funds & ETFsExplore analysis of some of the most popular inverse and leveraged-inverse ETFs that track equity indexes, and learn about the suitability of these ETFs.
InvestingWe look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.
Investing BasicsRetirement planning using high-risk options? It is possible, and studies confirm better yields than conventional methods. Here’s how.
Investing BasicsIn options trading, vega represents the amount option prices are expected to change in response to a change in the underlying asset’s implied volatility.
Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
The food and beverage sector exhibits greater volatility than the broader market and tends to suffer larger-than-average ... Read Full Answer >>