October 1, 2003

What happens when you write a covered call?
By John Brasher, CallWriter Publisher

It is easy for us at CallWriter to forget that not all our members or newsletter subscribers are truly conversant with what happens when you write a covered call. We talk in terms of writing a covered call for a whatever percentage return, but people look at their brokerage account statements and see their account's cash balance is a lot smaller. Here is a fair example of a question we get a lot: "I understood from the trade details received that I made $100 per contract for a 6.6% return, but I now have less money in my account now than when I began. What is happening? Please help me to understand what is going on in my account."

Remember that a covered call position is the simultaneous purchase of stock and sale of call options on those shares. Upon running the trade, you are long the stock and short the calls. If the calls are exercised, you are legally obligated to deliver shares of the underlying stock, but this is no problem because you already own the shares of of stock underlying the call options. This is why the position is a "covered" call - the stock you bought covers the calls sold. If you did not own the stock, the calls sold would be naked. A covered call trade consists of two financial transactions:

Since the stock will always cost more than the premium received from selling the call, the covered call trade will generate a net debit. For example, if you pay $15 for the stock and sell the 15 call for a $1.00 premium, your net debit will be $14. This trade sets up a flat return of 6.6% when it is entered ($1.00 / $15), but this is not yet a realized profit (or loss). When the trade is run, your account would show that the $14 has been debited from your account, so there will be less money there than before. The premium received does not show as a profit because the trade generates a net debit upon entry. However, the premium received is reflected in the net debit, since the stock cost $15 and your account was only debited $14.

Following the trade, there is now stock in the account to balance out the net debit, so your account would look like this:

Before entering the trade, your account had $15 per share in cash. But upon trade entry, your account looks different. Your cash has been reduced by a net debit of $14 per share, so only $1.00 per share remains in the account, and there is now stock in your account worth $15/share. Since you paid $15 and there is now $16 of value in the account, it appears you have made a $1.00 profit. Aah, but that profit has not yet been realized, because the trade is not over. So there is no profit realized at the moment of writing a covered call, despite receiving a $1 premium. From an accounting standpoint, the $1 premium received is not treated as a profit, but as a reduction in your basis in the stock, which is why we refer to the transaction as generating a net debit of $14, not a debit of $15 and a $1.00 profit. Now let’s look at what happens after the trade is entered:

You are called out of this position:
When the stock is called out (meaning the call options you sold are exercised) and sold at $15, you will realize the $1 profit. And in that example, $1.00 is all you will make, even if the stock goes to $20, because you are obligated to sell the stock at $15 if you are called out. By making the $1.00 profit, you have now realized the return of 6.6%, the money ($15/share) is safely back in your account, and you no longer own the stock. All trade risk has terminated. Now you have a profit from an accounting standpoint, because the $15 you paid for the stock is back in your account along with the $1.00 premium. If you are called out of the stock at the $15 strike price, your results would look like this:

You are called out of an OTM call:
The very best thing of all in writing covered calls is when you get called out of an out-of-the-money (OTM) call. An OTM call is one whose strike (exercise) price is HIGHER than the stock's price. In our example, the closest OTM call to the stock's $15 price would be the 17.50 call. So let's assume that instead of writing the 15 call for a $1.00 premium, you wrote the 17.50 call for a $0.40 premium. Now, look at what happens when the stock goes up enough that you are called out of the underlying stock at the OTM 17.50 strike price:

Great googly moogly! In this example, you made $2.89, because despite receiving the rather small premium at trade entry, you got called out and sold the stock at $17.50. This is a 19.3% return for a trade that you were in for less than a month. When you write OTM calls, you are not always called out, of course. And if you are not called out, then you don't do nearly as well. If you had not been called out in this OTM example, the return just from receiving the $0.40 premium would have been only 2.66% - not bad for a month, but nothing to dance in the streets over.

You are not called out:
The great thing about being called out of a covered call position is that you no longer own the stock and your return is then forever cast in stone (until your Uncle Sam puts his hand in your pocket). But when you are not called out, you still own the stock. You must sell it on your own. If the stock is not called out, your profit will be the $1 premium received less any loss you take on selling the stock. In this example let’s assume that the 15 call expires worthless (so you still own the stock) and that you sell the stock at $14.90:

In example 3 above, you didn't realize a $1.00 return, only a $0.90 return. This dropped your return slightly from 6.6% to 6%, not much of a diminution of your profit. Because the option expired worthless, you didn't have to buy back the calls you sold. In the next example, we see what happens when you DO have to buy back the calls (which never go to zero before expiration).

Here's another possible wrinkle: you are not called out, but the stock drops and you decide to close the position in order to avoid a loss. In example 4, let’s assume you are not called out, that you buy back the call for $0.10 and sell the stock at $14.30:

Why buy back the call? You have to do that in order to sell the stock and close the position. The stock covers the calls sold, so you cannot liquidate the stock while you are still short the calls. In this example, you made only $0.20, because despite receiving the fat premium, you lost money on the stock and had to buy back the calls. This leaves you with a 1.34% return, which technically is a profit, but most traders would be in the red after trading costs.

When the fat lady sings...
As they say in opera, its not over until the fat lady sings. Similarly, the final results of the trade are not known until you close the position. A covered call trade is closed when:

1)  the call options written have
       •been exercised
       •been repurchased, or
       •expired worthless,

        and

2)  the stock has been sold.

The trade ultimately might be a winner or loser, but you don’t realize or even know the final return or loss until the position is closed. What you do after entering a trade can be as important as choosing the trade and getting a good fill (good execution) on the trade. There are strategies for increasing your return and for mitigating an imminent loss, but these strategies are the subject of other newsletter articles. Until next time,

Good luck and good trading!