Possibly the most routinely used option trading strategy beyond simply buying calls or puts is the "covered call." As most people define it, this strategy involves selling (or "writing") a call option against a stock position. Typically this involves selling a call against a stock position already held. Other times an investor may see fit to buy 100 shares (or some multiple thereof) of some stock and simultaneously write one call option per each 100 shares of stock held.
The Standard Covered Call
Most often the standard covered call is used to hedge the stock position, and/or to generate income. Some will debate the usefulness of a covered call as a hedge simply because the only hedge provided is the amount of premium received when the option is written. As an example, assume that an investor buys 100 shares of stock for $50 a share and sells a call option with a strike price of 50, collecting a premium of $2. At this point, he has paid $5,000 to purchase the stock (ignoring fees) and has received $200 to write the call option. As a result his breakeven price on this particular trade would be $48 a share ($50-$2) at the time of option expiration.
In other words, if the stock fell to $48 a share he would lose $200 on the stock position, however, the option would expire worthless and he would keep the $200 premium, thus offsetting the loss on the stock.
If the stock were to rise above the strike price of 50 at the time of option expiration, the stock could be "called away" from the investor. In fact, the maximum profit potential on this trade, up until option expiration, is $200 [((strike price + premium received) – stock price paid) *$100]. This points out one of the potential flaws that most people don't consider in entering a typical covered call position: the trade has limited upside potential and unlimited, albeit slightly reduced, downside risk.
For this reason, investors will often write options that are reasonably far out of the money in hopes of taking in some income (i.e., premium) while also reducing the likelihood of getting their stock called away. Another problem related to the typical "buy/write" strategy (i.e., buy the stock and sell the call) is that the amount of capital needed to buy the stock can be relatively high and the rate of return can therefore be relatively low. So let's consider an alternative strategy for an investor interested in generating income without the expense and unfavorable reward-to-risk scenario associated with the typical covered call positions.
The Directional Covered Call Without The Stock
In this iteration of the covered call strategy, instead of buying 100 shares of stock and then selling a call option, the trader simply purchases a longer dated (and typically lower strike price) call option in place of the stock position and buys more options than he sells. The net result is essentially a position also referred to as a calendar spread. If done properly, the potential advantages of this position relative to a typical covered call position are:
- Greatly reduced cost to enter trade
- Potentially higher percentage rate of return
- Limited risk with the potential for profit.
To better illustrate these potential benefits, let's consider one example. The stock displayed in the left hand pane of Figure 1 is trading at $46.56 and the December 45 call option is trading at $5.90. The typical buy/write play is built as follows:
-Buy 100 shares of stock at $46.56
-Sell one December 45 call at $5.90.
The investor would pay $4,656 to buy the stock and would receive a premium of $590, so the effective breakeven price on this trade is $40.66 ($46.56 – $5.90). The maximum profit potential on this trade is $434 ($45 strike price + $5.90 premium minus $46.56 stock price). In a nutshell, the trader puts up $4,066 in hopes of making $434, or 10.7%.
Now let's consider an alternative to this trade, using just options to craft a position with a lower cost, a lower risk and greater upside potential.
For this example we will:
-Buy three January 40 calls @ $10.80
-Sell two December 45 calls @ $5.90
The cost to enter this trade and the maximum risk is $2,060, (200 x $5.90 - 300 x $10.80) or roughly half of the amount required to enter the trade displayed in Figure 1.
There are several important differences to note:
- The position in Figure 1 has limited upside potential of $434 and costs over $4,000 to enter.
- The position in Figure 2 has unlimited profit potential and costs $2,060 to enter.
- The position in Figure 1 has a breakeven price of 40.41.
- The one in Figure 2 has a breakeven price of 44.48.
An investor holding either position still needs to plan in advance regarding what action they would take—if any—to cut the loss if the stock does in fact start to decline in a meaningful way after the position is entered.
For illustration purposes let's fast forward to see how these trades turned out. By the time of December option expiration, the underlying stock has advanced sharply from $46.56 to $68.20 a share. The investor who chose to hedge his position and/or generate income by taking the trade in Figure 1, would have had his short call exercised against him and would have sold his stock at the strike price of the option he sold, or $45 a share. As a result, he would have earned a profit of $434 on his $4,066 investment, or 10.7%.
The investor who entered the trade in Figure 2 could have sold his three long January 40 calls at 28.50 and bought back the two short December 45 calls at 23.20 and walked away with a profit of $1,850 on his $2,060 investment, or 89.8%.
The Bottom Line
The results of one ideal example by no means guarantee that one particular strategy will always perform better than another. Still, the examples shown here do illustrate the potential for using options to craft trades with much greater potential compared to simply buying stock or using standard hedging strategies.