www.OptionsEducation.org

Income Generation: Using Covered

Calls and Cash-secured Puts

June 20, 2019 Joe Burgoyne Director, Options Industry Council

Presentation Outline

• Characteristics of Covered Calls

• Covered Call Example

• Planning & Considerations

• Myths & Misconceptions

• Introduction to Cash-Secured Put

2

Covered Call Definition

• Covered call: investor simultaneously • Writes (sells) one or more equity call contracts

• Buys equivalent number of underlying shares

• One short call for each 100 long shares

• If stock bought and call written at same time

• “Covered write” or “buy-write”

3

Why Write Covered Calls?

• Primary goal – increase returns

• Call premium received and kept (assigned or not)

• Generate additional income (over any dividends)

• Call premium’s limited downside benefits

• Lowers stock’s break-even point (BEP) by call premium amount

4

Questions To Consider

What are the covered call writer’s obligations?

Why is the short call considered “covered”?

What are the covered call writer’s concerns?

5

Covered Call Writer’s Obligations?

• Like any call writer (short call position) • Has the obligation to sell underlying shares

• At strike price

• If assigned

• Assignment (your potential obligation) • Possible at any time before expiration

• Equity options are American-style

• In return for this obligation • Call writer receives and keeps option premium

6

Why Is the Short Call “Covered”?

• Long stock “collateralizes” short call obligation

• If assigned → shares to be sold already purchased

• Upside loss potential of short call is covered

• Any upside loss offset by stock gain

• Remember

• Upside loss potential for uncovered call is unlimited

7

Covered Call Writer’s Concerns?

• Where’s the risk with a covered call? • Risk is in the long stock

• Upside stock profit potential is limited • Assignment → stock sold at strike price • Short call loss reduces long stock profit

8

Long Stock Covered Call

Covered Call: Profit and Loss at Expiration

• Upside profit potential is limited • Strike price – stock price paid + call premium received

• If assigned stock sold at strike price

• Break-even point • Stock price paid – call premium received

• Downside loss potential is substantial • Downside risk is with stock

• Option in this case offers only limited protection

• Entire stock cost less call premium received is the risk

9

Covered Call Example (OTM)

You own 100 XYZ shares trading at $52.00

• Neutral to moderately bullish over next few months

• Want to generate income in a stable market

• You have target sale price for stock

Sell 1 90-day XYZ 55 call at $1.75

Total premium received = $175.00

10

Covered Call Example (OTM)

Own 100 shares XYZ at $52.00

Sell 1 XYZ 55 call at $1.75

11

Long Stock Profit/(Loss) at Expiration

Short Call Profit/(Loss) at Expiration

Net Profit/(Loss)

Stock Price at Expiration

0 $1.75

($2.00)

($7.00)

($12.00)

$1.75

$1.75

$1.75

($0.25)

($5.25)

($10.25)

$50.00

$45.00

$40.00

$8.00

$3.00

($3.25)

$1.75

$4.75

$4.75

$60.00

$55.00

$52.00 $1.75

Covered Call Example (OTM)

Own 100 shares XYZ at $52.00

Sell 1 XYZ 55 call at $1.75

Maximum Profit if Assigned: Effective Stock Sale Price –

Stock Price Paid ($55.00 + $1.75) – $52.00 = $4.75

$475.00 Total

Break-even at Expiration: Stock Price Paid –

Call Premium Received $52.00 – $1.75 = $50.25

12

5

5

50 55 60

0

–

+

Long stock at $52.00

BEP $50.25

Covered Call Example (ITM)

You own 100 XYZ shares trading at $67.00

• Neutral to moderately bearish over next few months

• Want to generate income in a stable market

• You have target sale price for stock

Sell 1 45-day XYZ 65 call at $3.75

Total premium received = $375.00

13

Covered Call Example (ITM)

Own 100 shares XYZ at $67.00

Sell 1 XYZ 65 call at $3.75

14

Long Stock Profit/(Loss) at Expiration

Short Call Profit/(Loss) at Expiration

Net Profit/(Loss)

Stock Price at Expiration

0 $1.75

($2.00)

($3.75)

($7.00)

$3.75

$3.75

$3.75

$1.75

-0-

($3.25)

$65.00

$63.25

$60.00

$6.00

$3.00

($4.25)

($1.25)

$1.75

$1.75

$73.00

$70.00

$67.00 $1.75

Covered Call Example (ITM)

Own 100 shares XYZ at $67.00

Sell 1 XYZ 65 call at $3.75

Maximum Profit if Assigned: Effective Stock Sale Price –

Stock Price Paid ($65.00 + $3.75) – $67.00 = $1.75

$175.00 Total

Break-even at Expiration: Stock Price Paid –

Call Premium Received $67.00 – $3.75 = $63.25

15

5

5

60 65 70

0

–

+

Long stock at $67

BEP $63.25

Planning and Considering What-Ifs

Scenario 1

What should you do if XYZ rises above $55.00 prior to expiration?

A. Do nothing and wait for assignment.

B. Buy back the call and keep the stock.

C. Close the entire position by buying the call and selling the stock.

When should you choose between A, B, or C?

Market conditions can change, but…you should have a plan when you initiate the position.

17

Scenario 2

What should you do if XYZ is unchanged at $52.00 at expiration?

A. Write another call.

B. Sell the stock.

C. Employ another strategy

There is no “objective answer” to this question. Every investor must make an individual decision.

18

Scenario 3

What should you do if the price of XYZ begins to decline sharply?

A. Write another call (at a lower strike?).

B. Hold the stock.

C. Buy back the short call and sell the stock.

A prudent investor might use stop loss orders to protect against sharp declines in the underlying.

19

Start With A Plan

• Start with cash

• You’re buying underlying shares

• Full cash amount or on margin?

• Find a stock

• Your forecast is neutral to bullish

• Buy stock / sell call

• Call in-the-money or out-of-the-money?

20

Factors to Consider

• Be willing to sell stock at strike price • Manage position if necessary

• Have a stop loss point • Requires discipline

• Diversify • Multiple stocks and/or industry sectors • Write in-the-money and out-of-the-money calls

• Do it again? • Always be looking for opportunities

21

Key Considerations

• Option writers (sellers) MUST ALWAYS be prepared for assignment

• Requires vigilance and monitoring against early assignment (Impending dividends?)

• ONLY sure way to avoid assignment is to close the position

• RISK is in long stock position

• Small downside protection with large upside limitation

• Strike choice is paramount and is a trade off in priorities

22

Cash Secured Put Writing

Characteristics of Cash Secured Puts

• Typically involves selling ATM or OTM options

• Assignment is potentially welcome and desirable

• May be possible to buy shares below current market price with funds set aside

• If assigned, investor now has risk of owning the stock or ETF

• Can potentially earn additional interest income on funds set aside

24

Short Put & Covered Call Risk

25

0

–

+

Short Put

0

–

+

Covered Call

Does this profit and loss graph look familiar?

Writing OTM Puts: Primary Objective of Buying Stock

26

XYZ Options

Calls Puts

May 75 $8.20 $1.30

80 $5.00 $3.10

85 $2.70 $5.80

Jun 75 $9.00 $1.95

80 $5.90 $3.90

85 $3.60 $6.60

Data on XYZ:

Currently trading at $81.50

• 52-week high = $86.50

• 52-week low = $78.50

Your objective:

You’d like to buy XYZ stock

at $80 or less in about 3 months

Action:

Date: March 20

Sell 1 XYZ Jun 80 put at $3.90

Not including transaction costs

OTM Cash-secured Put at Expiry

27

Break-even at Expiration:

$80 – $3.90 = $76.10

Maximum Profit:

$3.90 premium received

$390 total

5

− 5

75 80 85

0

–

+

BEP $76.10

$3.90 premium

is profit/income

Long stock

at $76.10 net

Not including transaction costs

Key Points to Consider

• Assignment is not guaranteed • May miss out on buying opportunity if shares never dip

• Might pay higher than current market price if shares are purchased after a rally

• If assigned, new risk is in long stock • Shares might not only dip but plummet

• Potential for large losses should stock go to zero

28

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