Risks and rewards in covered call writing: selling a covered call option earns a premium, but consider the risks before diving in

Money Digest, August, 1997 by Paul J. Finnegan

Suppose you believe that your stock will stay at the same level or will move slightly higher in the short term. In this case, you may use the covered call writing strategy to generate income.

How does it work? You sell an out-of-the-money call against a stock that you already own.

Example: You bought the stock at $41-1/2. Then you sell a three-month 45 call at $1-1/2.

(This example does not include commissions, which, should be taken into consideration before entering into any option position. Taxes are also a consideration and should be discussed with a tax adviser.)

When you sell an out-of-the-money call against a stock you already own, you receive a premium in exchange for agreeing to sell your stock at any time prior to expiration of the call at a specified price you are comfortable with. By selling a covered call, you are making an advance decision about the price at which you are willing to sell your stock. You are paid a premium for making this decision. Depending on the stock price during the life of the call contract, you may or may not be obligated to sell your stock. The stock could decline and the loss would be offset only to the extent of the premium received. Let us see what happens:

* You bought 100 shares at $41-1/2

* You sold one three-month 45 call option at 1-1/2

* The breakeven is

41-1/2   (Stock Cost)
- 1-1/2  (Call Premium)
40       (Breakeven)

Three things can happen by the time the option expires in three months:

1. Stock moves above $45: If the stock rises above $45 a share, you are obligated to deliver 100 shares of stock (1 options contract is equivalent to 100 shares of stock) at $45 no matter how high the stock has risen. In exchange, you are paid the $150 premium (1-1/2 premium x 100 shares = $150) for this obligation.

Assigned on the 45 call:

Sell 100 shares of stock   $45.00
Less Breakeven cost         40.00
                             5.00
Your profit ($5 x 100)    = $500)

2. The stock goes below $45: If the stock goes below $45 a share, the 45 call option will expire worthless. You then own the stock at $40 (breakeven price). Any amount by which the stock price is below 40 represents a loss. You then have the ability to sell another call, taking in additional premium and further reducing the breakeven cost.

3. At a stock price of $45 the investor could be in either one of the above situations.