DataDrivenInvestor
May 1
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Mike Toney-Hoffman
A call option is a contract that gives the buyer the right to purchase 100 shares of stock at the strike price. For example, if you buy a call option for stock XYZ with a strike price of $100, you will have the right to purchase 100 shares of stock at $100/ share.
The call option buyer must pay a premium to purchase the contract. This premium is constantly changing depending on the stock price and implied volatility.
Traders can also write or sell call options. Selling a call is the opposite of purchasing one, so you will collect the premium for accepting the obligation to sell 100 shares of stock at the strike price.
The covered call strategy is when you own 100 shares of a stock and sell a call against those shares. You simply promise to sell your shares to collect the option premium as income. This strategy is a good hedge if you are bullish on the stock long-term but believe it will come down or not move in the short-term.
The primary risk involved with this strategy is not the call option; it is the 100 shares of stock. However, a few scenarios can happen after selling a covered call.
It is good when the stock doesn’t move because you make money on the call, and the shares don’t affect you.
If the stock price goes above the call's strike price, you may be obligated to sell them at the strike price. For example, let’s say you bought stock XYZ at $90/ share and sold a covered call with a strike price of $100. If stock XYZ goes to $110, you will still be obligated to sell the shares at $100. You will still collect the premium, but you will miss out on share price appreciation.
When the stock declines in price, the shares lose money, and the call option makes money. The covered call will help hedge your portfolio, but you can incur significant losses if the stock falls hard.
If you own 100 shares of stock, this is 100 deltas of exposure. Most people sell covered calls with a delta of .30, which will hedge 30 shares of your stock. The 100 shares of the stock are the most prominent risk because they have more delta than the covered call. If the stock falls, the delta of the call will drop as well. Therefore, you will be less hedged when the delta drops as the stock falls. If the call delta gets too low, consider taking profit and selling a new covered call.
You have more options if you want to hedge your stock position with more than just a covered call. For example, instead of collecting the premium as income, you can spend it on buying a put option. When you buy a put option, the risk is limited to the premium paid, and it can provide more protection than a covered call.
Purchasing put options with covered call premium may sound like a free hedge. However, if the stock increases rapidly, you will lose a lot of money on both the covered call and the put. Fun fact: this is what Bernie Madoff told his clients he was doing to outperform the market.
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