Writing (selling) Covered Calls
Writing covered Calls combines a long stock position with a short Call option. This strategy is to be utilized by an investor that believes the underlying stock may stay in a neutral to moderately bullish range. This investor also believes that the stock will not likely undergo a serious decline, and that downside is limited. This strategy is LESS risky than simply owning the stock, as the Call option premium received provides a limited downside cushion during market declines. Let's examine the trade characteristics...
Let's assume an investor is bullish on BVF, and decides simply to buy 1000 shares at $20.00. The moment BVF moves above or below the investors purchase price, that investor is either in a gain or loss position. This long stock position has unlimited upside and the investor is risking $20/share or in this case $20,000.00.
The covered Call strategy reduces an investor's risk as follows. Let's assume the same investor purchases the same stock position, but decides to sell 10 BVF Dec $22.50 Calls @ $1.00 against the long stock position (10contracts x 100shares/contract = 1000 shares coverage). The investor will receive into their account $1000.00 (10x100x$1= $1,000.00) in option premium. In return for this premium, the investor in agreeing, by contract, to sell their BVF shares at $22.50 up until expiration. Now what happens? Let's look at possible outcomes...
If at expiration, BVF is trading above $22.50, the investor will have their stock exercised away from them, therefore exiting the stock position at $22.50 (the strike price of the option). The strike price ($22.50), plus the option premium received ($1/share), or in this case $23.50 total, is the effective exit price of the entire trade. A gain of $3.50 per share or $3,500.00.
If at expiration, the stock price has risen, but is still below the strike price of the short Call ($22.50), the investor will keep the stock, and keep the premium. The short option expires worthless (this is a desired outcome), and the investor may then be able to sell another Call option against the stock position for more premium.
If at expiration, the stock has dropped below the entry price ($20.00), say to $19.00. The long stock investor would be down $1,000.00. However, the covered Call writer would be even. The investor that wrote the Calls against the stock received $1,000.00 in option premium, that option would expire worthless, leaving the investor still holding the stock and the option premium. In the case of the covered Call writer, a loss does not occur until the stock drops below the entry price ($20) less the option premium received ($1 per share) or $19.00. If the stock drops below $19.00, both the covered Call writer and the long stock investor will be down on their trades.
Covered Call writing can be used to provide limited downside protection, cash flow improvement in neutral markets or as a stock repair strategy. The accumulated option premiums received act to lower the original cost of the stock purchase.
