Covered Call

A call writing strategy or a covered call strategy is when an investor or trader sells a call option to either enhance his portfolios earnings or to mitigate the portfolios risk profile.  This strategy is often used by both experienced investors and investors who are new to options trading. There are two main reasons for an investor to use a call writing strategy.  The first is to benefit by receiving premium from a sold option, and the second is to protect a portfolio from a market falling.  The definition of a call writing strategy is a call sold on an instrument that is currently owned by the investor.  A call writing strategy mitigates an investors risk and therefore it is often used in lieu of writing calls “naked”.  A naked call strategy is one where the investor sells a call, but does not own the underlying instrument.

Options Review

For those who are new to options, let’s review some basic options terminology. A call option gives the buyer the right, but not the obligation, to buy the underlying instrument at a specific price (the strike price) on or before a specific date (option expiration date). For example, if you buy November $1.50 EUR/USD call, you have the right, but not the obligation, to buy EUR/USD at $1.50 (strike price) per dollar on or before the expiration date which in this case would be in November.  Each option contract an investor buys is for a specific amount of dollars. The amount an investor pays for an option is called the premium (say in this case $0.001 per dollar).  When you are an option buyer, your risk is limited to the premium you paid for the option. But when you are a seller, you assume unlimited risk.

What is the benefit of a call writing strategy?

In a call writing strategy, the investor is the option seller.  A call writing strategy infers that the investor will be selling a “covered call”, which will limit the risk that the investor will assume.    “Covered” means that the investor will own the underlying instrument (in the example above, a currency pair).  The investor is covered against unlimited losses in a call writing strategy in the event that the market goes above the strike price and is the option is exercised.

When using the call writing strategy the investor will have slightly different risk profile to a profile when owning just the underlying instrument like a stock.  If the option is exercised at maturity (the expiration date) in a call writing strategy the investor will keep the premium, but the underlying asset will be sold at the strike price.  For example, let’s assume an investor owns the SPY Spider ETF.  If the investor sells a Call option on the SPY at a strike price of $120, when the SPY is at $110, the investor would receive the premium of $2.  If the SPY market does not move, or moves only slightly, the investor can receive the entire premium without giving up the long position in the underlying asset.  If the market moves above $120, the investor will have to give up the underlying SPY position at $120.  In this case, the investor would be selling his SPY (which he already owned) at $120, plus receiving a premium of $2.  Covered call strategies are used in almost all capital markets.  They are most common in the equity markets.  Investors in the equity market will use covered call strategies, enhance their returns, mitigate risk  and for tax efficient reasons.

There are a number of reasons investors use a call writing strategy.   One is to receive income from the premium of selling a call.  A second reason to use a call writing strategy is to take profit at a level above the current market level.  A third is to somewhat mitigate the downside risk of the market.  When an investor sells a call option, the risk is essentially a short position in the market.  Shorting the market outright can be a risky proposition, and it is important for an investor to understand the risk of naked option selling prior to entering to that type of transaction.  Covered calls are a very important strategy to use for portfolio investors, and should be considered if your strategy is geared to earning premium or portfolio protection.