I’m just reading through an old article (“Dominguez Barry Looks at Covered Calls,” appearing in the July 20, 1992, issue of Derivatives Week) and 'm alittle confused here.
In it, they quote an Australian fund manager:
I don’t really understand this at all. If volatility is high, isn’t writing call options a poor strategy? Wouldn’t it be better to buy call options?
My thinking is: Since volatility is high, his returns are unknown. Hanich can’t be sure of what rates will be, so he can’t “know” how many will be called, etc.
If somebody more knowledgable than me can explain his thinking/strategy to me, that would be very helpful. I’m really interested in this type of thing, but can’t quite get my head wrapped around it.
“Writing a covered call” means that you own shares of the stock before your write the call. The idea is that you expect that the stock won’t reach a certain price by a certain date. So you write the call. If the stock goes down, you get to keep the money paid you for the call.
If it goes up, you have to sell the stock at the call price, which is below the market value of the stock. However, it will be higher than the amount you paid for the stock, so your loss is limited and you may even make a profit (albeit a reduced one).
An example: You own 100 shares of Amalgamated Mudd. Current share price is $50. You write a covered call at $55. The buyer pays you a fee (say $2/share). If the stock stays below $55, you get to keep the fee and the stock. If the stock goes to $57, you break even (you make a profit between 55 and 57). If the stock goes above $57, you lose money. But since you owned the stock, you don’t have to go out and buy it to make the call (if you didn’t own the stock, you’d have to buy the stock at $57 and sell it at $55).
If you originally paid $40 for the stock, you still have a profit overall. (All these numbers exclude broker’s fees, which gum up the works).
So if the stock fluctuates, writing a covered call can increase your income if the stock drops below the call price. The author is setting a particular limit (8.5% above the current price) that gives you the chance to make the extra money and so that the “loss” is actually an 8.5% increase in the stock price.
Just to clarify Reality’s post, if the stock goes above $57, you don’t actually lose money, you have opportunity loss, which means that even though you made $7, you could have made more if you hadn’t written (sold) the call option. Writing covered calls reduces the risk of your stock ownership at the cost of some potential gains. If the underlying stock is very high volatility, then writing calls is a great way to reduce the volatility you experience and potentially increase profit. I do it regularly as a means of additional income on stock holdings.
