Subject: Derivatives - Stock Option Covered Calls

Last-Revised: 27 Oct 2010
Contributed-By: Chris Lott (contact me), Art Kamlet (artkamlet at aol.com), John Marucco

A covered call is a stock call option that is written (i.e., created and sold) by a person who also owns a sufficient number of shares of the stock to cover the option if necessary. In most cases this means that the call writer owns at least 100 shares of the stock for every call written on that stock.

The call option, as explained in the article on option basics, grants the holder the right to buy a security at a specific price. The writer of the call option receives a premium and agrees to deliver shares (possibly from his or her holdings, but this is not required) if the option is called. Because the call writer can deliver the shares from his or her holdings, the writer is covered: there is no risk to the call writer of being forced to buy and subsequently deliver shares of the stock at a huge premium due to some fantastic takeover offer (or whatever event that drives up the price).

Note the difference between selling something in an opening transaction and selling something in a closing transaction. When you sell a call you already own, you are selling to close a position. When you sell a call you do not own (whether it is covered by a stock position or not), you are selling to open the option

position; i.e., you are writing the call. You might compare this with selling stock short, where you are selling to open a position.

A call writer is covered in the broker's opinion if the broker has on deposit in the call writer's option account the number of shares needed to cover the call. The call writer might have shares in his or her safe deposit box, or in another broker's account, or in that same broker's cash account -- this makes the investor covered, but not as far as the broker is concerned. So the call writer might consider himself covered, but what will happen if the call is exercised and the shares are not in the appropriate account? Quite simply, the broker will think the call is naked, and will immediately purchase shares to cover. That costs the call writer commissions -- and the writer will still own the shares that were supposed to cover the call!

A call is also considered covered if the call writer has an escrow receipt for the stock, owns a call on the same stock with a lower strike price (a spread), or has cash equal to the market value of the stock. But a person who writes a covered call and doesn't have the sahres in the brokerage account might be well advised to check with his or her broker to make sure the broker knows all the details about how the call is covered.

While the covered-call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire. I.e., the covered call writer will be forced to deliver shares (known as having the shares "called away").

If the call writer does not want the shares to get called away, he or she can buy back the option if it hasn't been exercised yet. And then the call writer can roll up (higher strike price) or roll over (same strike price, later expiration date), or roll up and over. Of course the shares could be bought on the open market and delivered, but that would get expensive.

If you write a covered call and are concerned about indicating specific shares to be delivered in case you are called, it may be possible to have your broker write a note on the call to specify a vs date. The call confirmation might read: "Covered vs. Purchase 4/12/97." In other words the decision on which shares you are covering is made at the time you write the call. This should be more than enough to prove your intent. What your individual broker or brokerage service will do for you is a business matter between them and you.

My personal advice for new options people is to begin by writing covered call options for stocks currently trading below the strike price of the option; in jargon, to begin by writing out-of-the-money covered calls.

For more information, you might visit Born To Sell, where you'll find a comprehensive tutorial on covered calls:
http://www.borntosell.com/

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