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An explanation of call options and a brief introduction to the covered call strategy

Clients sometimes as us about call options, a type of security we do not currently use.  Since it is important to thoroughly understand a strategy and asset class before investing, we present a brief and simple introduction to calls, with an emphasis on covered calls.

A call option is a special kind of security that grants the owner the right to buy a security on (or up to) a certain expiration date at a certain pre-specified price (called the strike price).  Call options can be used in your portfolio to fill a number of different roles:  they can be used as part of a levering or speculating strategy, where an investor buys call options looking to profit from the movement of a stock without having to buy the stock itself.   They can also be used as part of a hedging strategy, where the investor buys call options to offset other exposure.  However, this white paper is going to focus on how options are used to generate income on equity portfolios. 

While there are many different strategies one can use to generate income from their portfolios using options, the most straightforward and frequently used way is called the covered call strategy.  In this strategy, the investor sells options on the stocks he or she owns.  The investor collects a premium from the sale, and can sell the stock to cover the call if the stock price moves above the strike price.  Essentially, the investor locks in a premium in exchange for the payoffs if the stock moves above the strike price.  The lower the strike price, the higher the initial payoff.  

Let's illustrate this with a real world example:  Suppose you own some IBM and are going to write covered calls on your shares.  IBM is currently trading at around $125 a share.  January call options with a strike price of $135 are currently worth around $3.50.  If you write (sell) a call, you automatically receive $3.50.  Lets see what happens to the stock in different situations.

Case one: The price of IBM stays at $125 through January.  The call option expires without being executed.  You keep your stock, and the $3.50 you got for the call option.  Your payoff is $3.50.

Case two: The price of IBM falls to $100 in January.  The call option expires without being executed.  You keep your stock (now only worth $100), and the $3.50 you got for the call option.  Your payoff is -$21.50.  

Case three: The price of IBM rises to $135.  The holder of your call option executes it.  You sell the call-owner your stock for $135 and keep the $3.50 you got for the call option.  You have $138.50 in cash.  Your payoff is $13.50.

Case four: IBM has a blowout quarter and the price rises to $205 per share.  The holder of your call option executes it.  You have to sell the call-owner your stock for $135 even though its worth $205.  You still keep the $3.50 for the call option.  You have $138.50 in cash.  Your payoff is $13.50, but the holder of the option just made 20 times his investment.

The covered call strategy works well when stock prices stay in a relatively narrow band until the expiration date.  If the stock price rises significantly higher than the strike price, the investor is better served not having sold the call option.  Similarly, if the stock price falls more than the premium the investor received from selling the option, they would have been better off just exiting their position.  

An investor interested in writing covered calls must also take into account the transactions costs which may be associated with their strategies, especially if they need to cover their calls; selling out and re-buying their stock positions.  Depending on the broker and the size of the account, these transactions costs may considerably cut into the profitability of the strategy.

Even though it provides little downside protection, writing covered calls can be a sensible strategy for some individuals, especially those looking to generate income on their equity portfolio.  However, despite the seeming simplicity and "surefiredness" of this strategy, dealing with options always requires great care.  Options pricing is intricate, involving many factors less intuitive than strike price, and time to expiration.  Furthermore, options pricing is based on Nobel Prize winning theorems, as well as equations originally developed by Albert Einstein.  Needless to say, evaluating options requires considerable mathematical sophistication.  While you are unlikely to bankrupt yourself writing covered calls, failure to properly understand the complexities of options can hurt your performance considerably.  Ultimately, we recommend anyone considering this strategy make absolutely that they or their advisor understand the sophisticated details what they are doing.