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Saturday, May 13, 2006

Writing Covered Call Options

Every once in a while, I come across advertisements for "covered call writing" programs, where the indivdual selling the program makes it out to be the best thing since sliced bread. So do my students. In fact, one of them just asked me about this article (dated 4/29) in the Wall Street Journal titled "Buy-Write Strategy Could Help in Sideways Market" (online subscription required).

For those of you who aren't familiar with the term, let me give a little background. A call option is a contract that gives the holder the right to purchase a share of stock at a given price (known as the exercise, or strike price) for a certain term. The price paid for the option is known as the premium, and is received by the individual who grants (i.e. "writes") the option.

The option has value if the underlying stock has some chance of exceeding the strike price within the given time frame. For example, let's assume you had an option with a strike price of $30. If the stock price at the exercise date is $35, the option holder gets a payoff of $5 (i.e. they get to buy something valued at $35 for a price of $30). If the underlying stock is worth less than $30 at the expiration date, the option holder's payoff is $0, since the option remains unexercised.

Options are more valuable when there is more volatility in the price of the underlying stock, when the exercise price is closer to the current stock price, and when the term of the option is longer. The reason for the poitive relationships between the option premium (i.e. the prive or value of the option) and these characteristics is that they make it more likely that the stock price will be above the exercise price.

By writing call options on a stock you hold (known as a "covered call"), you are granting the option holder the right to purchase the stock from you in exchange for the premium on the option. So, in essence, you are trading away some of your future potential for appreciation in exchange for money now.

If you want to visualize the distribution of your expected returns from this strategy, start with the distribution of expected returns on a common stock. While I know it's stock returns aren't normally distributed, just use the typical bell shaped curve as a starting point. Writing the call option is equivalent to chopping off the right tail of the distribution (the "high return" states of the world) at the exercise price. However, since you receive the call premium up front, it also shifts the distribution a bit to the right.

So, like always, there's no free lunch in this strategy. If write options that give you a high premium (i.e. higher current income), you only get the income by giving up a greater amount of potential appreciation.

If you're interested in learning more about options, there's a pretty good primer at investopedia.com

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