Educational Programming Video
The Value Line Daily Option Survey
Program 6: Writing Covered Calls
In our last session, we reviewed writing uncovered options. In this session, we are going to discuss writing covered calls. As with our other strategies, we rank covered calls from 1 to 5, with 1 being the best for covered call writing.
What exactly is a covered call? A covered call is a combined position of owning a stock and writing a call option on this same stock. Being long the stock fully covers the risk of being short the call; therefore, you do not need to post margin on a covered call as you do when you write an uncovered call or put.
Why write a covered call? You write a covered call because you are bullish on the stock, but at the same time, you perceive the call to be overpriced with respect to future price movements. By writing a covered call, you pick up income by selling premium. At the same time, you give someone else the right (but not the obligation) to buy your stock at the strike price. In essence then, you are selling off some potential future gains in the stock.
Now let us look at an example. On October 25, you buy 100 shares of Microsoft at $60 and you write one January $65 strike call contract on the stock for $4. (Remember option contracts are in units of 100 shares.) The call that you wrote would give the buyer the right but not the obligation to purchase 100 Microsoft shares for $65 per share any time before the expiration date, which in this case is January 17th, 2001. Thus if the stock goes to $100 a share, someone else will have made the big profits.
Why write the call on your stock giving someone else the chance to make the really big profits? You do this because from a risk/reward perspective, the covered call has a better likely payoff. Implicitly, you believe that the premium that you collected is more than adequate compensation for forgoing gains above a certain level.
Let us look at the reduced risk. By selling the call you have lowered your cost of buying Microsoft to $56 per share ($60-$4). Now, you can only lose money if the stock falls below $56.
On the reward side, even if the stock does not rise, you still get to keep your $4 call premium. That represents better than a 6.5% return in less than 3 months (31% on an annual basis). In addition, although your gains are stopped out at a certain level, your returns can still be substantial. If the stock ends up at $65, you make $9 - $5 from a rise in the stock plus the $4 premium. Thus at $65 per share, you have beaten the person who only bought the stock by $4 and the person who bought the call by $8.
One of the biggest myths surrounding covered call writing is that it is a bearish strategy. This comes from the psychological perception that you don't want the person to whom you sold the call to have a better return than you do. In fact, covered call writing is bullish since you do better when the stock rises and worse when it falls.
How can the Value Line Daily Options Survey help you find profitable covered calls? Our system selects covered calls based on three different criteria. The first one is how bullish we are on the stock. This is done by the Value Line Common Stock Ranking system with a rank of 1 being the best.
The second is how much our model calculates the call to be overpriced with respect to future price movements. The third is a profile of how risky the combined covered call position is. Thus, a typical rank 1 covered call is one that is an overpriced call based on a rank 1 stock. This position will always have less risk than the underlying stock.
We believe that covered calls can form the basis of an option investment portfolio. Over the past 20 years, our recommended covered calls returned better than 27% per annum, beating the benchmark S&P 500 index more than 2/3 of the time.
In our next report, we will show how you can combine covered calls with other option strategies to achieve even better returns. We hope you'll join us.