Covered Writes
If you write a call on a stock and do nothing else, you can lose money even if the call is overpriced. Namely, the stock price may increase dramatically, causing the call to increase in value despite its original overpricing. And you will either have to repurchase the call for more than you got when you sold it, or the buyer of the call will exercise it, forcing you to purchase the stock at a high price so that you can deliver it, which is your obligation under the option contract.
One way to cover yourself is to purchase the stock simultaneously with your option write. This is called a covered write. In a covered write you are totally protected on the upside, as you can always deliver the stock if the call is exercised. In this position, the amount of premium you hope to earn is the premium of the call less its intrinsic value.
For instance, suppose you write a call for $7 with a strike price of $70 when the underlying is selling for $75. The intrinsic value of the call is $5 and the premium over intrinsic value is thus $7 – $5 = $2. The maximum you can gain is $2. If the stock closes above $70 at expiration, the call you have written will be worth the stock price less $70, which is to say, worth its intrinsic value, and you will have gained the $2. So on an non-margined investment of $75 less $7, or $68, you have earned $2, a raw return of about 3%. And if you accomplish this in a matter of weeks, this 3% annualized can be quite substantial.
However, you have some downside exposure because you are long the stock. If the stock price plummets much below the exercise price of the call, you will sustain a loss. In the above case, you are protected down to $68, at which point your covered write breaks even–the call is worth nothing so you gain the full $7 on your call sale, but you lose $7 on your long position in the stock. Below $68 you incur a loss.
You can reduce the chance of this happening by choosing a call whose strike price is far below the current price of the stock, but you will find that for such a call the premium over intrinsic value is small. For deep in-the-money calls, the annualized return from writing the call is almost always about equal to an interest rate in the area of T-bills.
More on this Thursday, June 17.