In the latest Best Game in Town, MarketShadows, March 10, 2013
Courtesy of Paul Price
From Investopedia: Definition of ‘Covered Call’
“An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium.”
Selling Covered Calls options represent a commitment to sell shares at a prearranged price (the Strike Price) through a set expiration date, if we are required to do so by the buyer of the calls. Option exercise takes place at the direction and timing of the person that is long those calls.
If a stock quote is below the call’s strike price at 4 p.m. on the last trading day prior to expiration, the call option will expire worthless. The buyer would have lost his bet and any option premium he paid. The writer (seller) of the calls would keep the underlying shares and the money he received upon sale of the options.
If the underlying shares are trading for even one penny more than the designated strike price on that last trading day before expiration, the calls will be automatically exercised. The call seller would deliver 100 shares per contract to the call option owner. He would get paid 100 times the strike price per contract on settlement date (because there are 100 shares per contract), three business days after the exercise occurred.
An example: Here is what the May 18, 2013 call option quote looked like on Home Depot (HD) as of 4 p.m. on Friday Mar. 1, 2013. HD’s 52-week range has been $46.12 – $69.19.
If you own 100 shares of HD and feel it is approaching a top you might be interested in selling a May 18, 2013 $70 strike price call. The last trade on that was for $1.73 per share.
The seller of one contract would collect $1.73 x 100 shares = $173. That would be credited to the seller’s account on the next business day. The seller’s obligation would be to stand ready to deliver the buyer’s shares if the option buyer decided to exercise the option.
Unless the option had been exercised early there are only two possibilities that can occur on the afternoon of May 17, 2013.
Selling the call brings in immediate income. It imposes a sell discipline on the call writer (seller) at a predetermined price. In this example, if HD goes up more than $1 per share by May 17, 2013, the shares will get called away at a $70 price. The option also protects against any drop in HD to $67.27 (but not lower), because the seller collected an upfront $1.73 per share, for 100 shares per option contract written.