Two weeks ago, I wrote about call options.
Essentially, call options allow us to lock-in our preferred purchase prices for stocks via contracts. During their contract durations, if these stocks rise significantly in prices, we would put them into effect and buy them at our preferred purchase prices, which are below their current prices. Such is a strategy for investors to keep accumulating these stocks at their preferred prices over time.
Here, this article shall revisit call options, not as buyers, but sellers of call options.
Sometimes, investors may sell call options of stocks they own for income (known as premium). I would explain how this works from a value investor’s point of view:
1. What is the Meaning of “Covered”?
Let’s say there is A Inc, a fundamentally solid company in the US.
Two individuals wish to sell 1 call option on A Inc. Each call option represents 100 shares. So, in the case of the first individual (Mr. A), he actually owns 100 shares of A Inc. Since he owns such shares, his position is known to be “covered”. Whereas for the second individual (Mr. B), Mr. B is not a shareholder of A Inc. Since he doesn’t own A Inc’s shares, his position is “naked”.
2. Why Sell Covered Call Options?
Supposedly, an investor owns 1,000 shares of A Inc. Each is now priced at $100 a share and it’s now a big part of his portfolio. As such, he has no intention of adding more shares / selling off its shares in the near future.
The investor calculated that A Inc would be overvalued if its stock price is $110 a share.
Thus, he chooses to sell 10 call options that allow his buyers to buy A Inc’s shares at $110 each over the next 3 months (contract duration). Here, let’s assume that the premium is $2 per share. Thus, the investor earns an upfront premium of $2,000 from selling 10 call options of A Inc.
Situation 1 – If A Inc Falls in Stock Price
Assuming that in the next 3 months, A Inc’s stock price fell to $90 a share.
In this situation, the 10 call options become worthless. This is because his buyers could invest A Inc’s shares directly in the open market for $90 each (which is below the option to buy its shares at $110 each). So, the investor who sold covered call options keeps the premium in full, which is $2,000 or $2 each.
That’s +$2 in premium gain.
But, he owns 1,000 shares in A Inc and is willing to hold onto them in the long-term. Temporarily, the value of his shareholdings drops from $100,000 ($100 each) to $90,000 ($90 each). This will be a -$10 in capital loss.
Combined, the investor incurs a net -$8 in capital loss (capital loss – premium gain). In a way, by selling covered call options, the investor can offset partially his capital loss with premium gains.
Situation 2 – If Its Stock Price Maintains at $100
This is an even better situation than Situation 1.
Still, the 10 call options are worthless as his buyers would buy A Inc at $100 in the stock market, not exercising their options to buy A Inc at $110 each. Hence, the investor keeps the premium in full.
More interestingly, the value of his shareholdings maintain at $100,000 ($100 each).
So effectively, the investor shall earn $2,000 (+$2) in premium gains in the last 3 months, even if the stock did absolutely nothing in that period of time.
Situation 3 – If Its Stock Price Increases at $109
This situation is even better than Situation 2.
Still, the 10 call options are worthless as his buyers would buy A Inc at $109 in the stock market, not exercising their options to buy A Inc at $110 each. Hence, the investor keeps the premium in full, which is $2,000 (+$2).
The value of his shareholdings appreciated to $109,000 ($109 each). That is a +$9 capital gain.
Combined, the investor’s total gain in that 3 months is +$11 ($2 premium + $9 capital gain).
Situation 4 – If Its Stock Price Increases at $120
In this situation, since it is above $110, the buyers of “10 call options” shall execute their options, buying 1,000 shares at $110 each from you. These buyers can either hold onto them or dispose of their shares immediately at $120 to realise capital gains.
The investor shall sell off all his shares at $110,000 ($110 each). It’s a +$10 from $100 3 months ago. Combined with the +$2 premium, the investor’s final gain is +$12.
However, since the stock price increased to $120, the investor forgoed his right to attain +$20 in capital gain as he sold his covered call options. In other words, he would earn $8 less from his shareholdings in A Inc.
That is the risk the investor is taking when he sells covered call options.
Conclusion:
All in all, selling covered call options is a method investors use to earn some “premiums” as they hold onto their shares.
Next, I’ll cover my learnings on selling put options. Stay tuned.
