Covered Call Writing

Risk Profile: OK, let's look at the actual mechanics of writing the covered call the, risk reward profile of a covered write and how we put the two elements together of the call and the equity option.

Covered Call Writing - Risk Profile

Once we have understood the two elements of the covered write, the equity option and the underlying stock, constructing the position is relatively simple. However, before we do I would like to take a look at the risk profile for this strategy and how the overall risk profile for the covered call is actually constructed from the other two elements.

On the left is the risk reward profile for the long stock which is the first part of the covered call. The price we bought at is represented by the vertical grey line, and the difference between profit and loss is shown by the purple line. Assume the stock price moves from left to right. As the price of the stock moves up, so we move into profit, and as the price falls we move into loss. Naturally without a stop loss our profit and loss is unlimited so the loss can go to zero, ( assuming the company goes bust, and likewise our profit is unlimited. This latter point is important because in a covered call, as you will see, part of the trade off is giving up the possibility of future profits. This is the risk profile for buying and holding stocks or shares.

The second element of the strategy is the short call, which is shown in the risk reward profile to the right. As you can see this is very different from the long stock profile. The profit on a short call is limited to the profit of the premium. As a writer you always keep this premium no matter what happens to the option at expiry. As the underlying stock increases in value, so your loss in the position will increase accordingly and is unlimited. As the stock price increases you will be forced to buy in the open market to deliver the underlying 100 stocks at the ( now much lower ) strike price, resulting in a large loss. This is the risk profile that you would take on if you sell a naked  call and why selling naked calls is so dangerous.

Finally we add the two strategies together in order to arrive at the risk profile for the covered call, which is as shown on the right. Let's look at this profile in more detail. As we can see, the downside risk still remains for the stock, which is still unlimited, but the premium of the option now gives us a fixed profit should the stock price increase. In combining the two profiles we have removed the unlimited risk of the short call, and capped our profits in the event that the stock value continues to increase. We have therefore given up future ' possible profits' in return for the premium. The word covered simply means that you are protected from unlimited risk.

Covered Call Writing - Downside Risk

Now, there is one area of this strategy that I would like to discuss in a little more detail at this stage, and that is the element of downside risk. If we look at the first risk profile, i.e. that is simply holding the stock long, we have unlimited risk on the downside and unlimited profit on the upside.  Do you remember the first two rules of trading:

Rule 1: There is only one rule in trading - Preservation of capital

Rule 2: Never forget rule one!

Remember! - preservation of capital is key to your survival and success. If you trade a long stock using the above profile, which is the way most people trade, you will fail - trust me. Why? because you have not limited your risk to the downside. In trading covered calls there are two ways to do this as follows :

1. We use a simple stop loss on the stock
2. We use a protective put to cover the position

Now the second of these strategies involves buying a put which will increase in value as the stock price falls. However the cost of the put will add to the cost of the trade and move it from a net credit trade to a net debit one, in other words you will be paying out more for premium on the put, than you will be collecting on the premium from the call. This is a more complex strategy called a Collar, which I cover on the online option trading site. It can be made to work as a strategy in conjunction with the covered call approach, but the trade will need attention all the time, and the put will probably be bought three months out or more, for the returns to work.

The approach I use myself is the first of these, which is to use a simple stop loss on the stock. The stop loss will protect you in the event of a fall in the stock price, and we then end up with a profile that looks like this shown on the right here. Now as you can see we have now capped the downside risk, by placing a stop loss in position below our opening trade, so now we have a much better looking profile, with limited downside risk, and limited upside profit. A true covered call.

Now applying the stop loss to the stock, does not add to the cost of the trade ( unless you use a guaranteed stop loss, which I never have but this is up to you ) so we have maintained our % return on the trade, which we will look at in a minute. However, there is one point that you MUST BE AWARE OF IN USING THIS APPROACH which is this :

Technically, it is possible that you could end up trading a naked call!!!!!! - HOW? - very simple - if you have sold a call, which is covered by the stock, and the stop loss then takes you out of the trade to protect your capital, you still have a short call open. Now if the stock has fallen so far to trigger your stock, your call would be practically worthless to the holder, and therefore very unlikely to be exercised as it would be far out of the money. However, technically you are trading a naked call, so that if this scenario happens, and your stop loss is triggered, you will need to close out your short call fast - Please remember this point - it is important.

OK, that's it on risk profiles on writing the covered call. Now let's take a look at the two simple strategies that I suggest you start with in learning about covered call writing, and then we will have a look at the likely returns available.

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