From the April 2013 issue of Futures Magazine • Subscribe!

How do I protect myself in a rising market when I write covered calls?

Question: How do I protect myself in a rising market when I write covered calls?

Answer: Simple. Roll the call.

Over the past year, the S&P 500 Index has continued its steady uptrend, reaching new all-time highs by the beginning of March. While this may be a good thing for the average investor, it has put some covered call traders in an uncomfortable position. A covered call is a market strategy that combines your stock position with a short call option position to generate additional income via the collection of the option premium. The success of covered call systems is well documented. In fact, the Chicago Board Options Exchange (CBOE) now publishes a covered call benchmark called the Buy-Write Index (BXM), which shows that a covered call portfolio can not only outperform a standard portfolio of S&P 500 stocks, but can do so while decreasing overall market volatility. However, in markets that rise relatively quickly, the benefits of collecting the option premium may be overshadowed by the performance limits placed on your position by the short option. In quickly rising markets, a stock may run straight through your option strike, leading you to not only miss out on a potential stock move, but putting you in a position where you’ll have your stock taken away, and potentially enduring some unintended tax consequences. 

What is a covered call?

A covered call is a stock and option position constructed in the following manner:

  • Step 1:  Buy 100 shares of a stock
  • Step 2:  Sell 1 call option with a strike price that is either equal to (at-the-money) or higher than (out-of-the-money) the current stock price.

The idea is to use the premium collected from the sale of the option to enhance the market returns generated by just the stock. To illustrate, consider the following example where you buy 100 shares of XYZ stock for $98 per share and you sell the 100-strike call at a price of $3.50. Then, the graph of your P&L would look much like the image below:

 

The red line shows your long stock position, while the blue line shows the combined stock and option position. The breakeven level on a covered call position is defined as the strike price plus the option premium, meaning that until the stock reaches a value of $103.50, the covered call outperforms simple long stock.

The problem arises when the stock rises above $103.50 per share. Now, the sale of the call merely limits the performance of your portfolio. Furthermore, if the stock remains above $100 on the expiration date of your option, you will be forced to sell off your stock at the stock price at the strike price. 

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