Let us understand what is covered call writing strategy using an example-
Consider an investor who is holding shares presently trading at $520.00. His investment horizon is 6-months. In 6-months' time, share price can either rise or fall. Investor is expects no volatility in the share price and the share price will remain below $600.00 for next 6-months. Also, the investor has no liquidity problem.
Suppose, if the share price falls below the cost then investor will not sell the shares instead will wait till the share price ramps up. However if the share price remains below the cost for a longer period (i.e., upto his investment horizon), there is a risk of investment fund getting stuck.
So to overcome this problem of funds getting stuck up, investor enters into a CALL option contract were in he is obligated to sell the shares if the share price rises above the strike price of $600.00 for a premium of $35.00. This will lead investor for giving up the upside potential of the share just to receive a small premium amount. If the share price remains below the strike price of $600 (which he already expects) then he can book a profit amount equal to the CALL premium received. Resulting in decrease in cost of holding the shares due to initial premium received on writing a CALL option. Therefore, effective cost to the investor becomes $520 - $35 = $485.00.
Why to do this strategy?
To generate income while holding the stock: Currently the stock price is $520.00. Investor expect the stock to be flat (i.e., non-volatile price belief) and in no hurry to offload the stock. It means he will keep on holding the stock unless the stock price significantly rises until then his investment is stuck up unless price rises. In order to generate some income on a regular basis (like cash dividend), investor can write a out of the money(OTM) CALL option.
Note: By doing this strategy, investor is possibly forgoing the upside potential of the stock (i.e., above the strike price of $600.00) because if the stock price happens to be higher than $600.00, he is obligated to sell the stock to fulfil the option contract (remember he contracted to sell the stock if the stock price happens to be more than the strike price by selling a CALL option).
Example:
Blue thin line represents stock purchased at $520.00 and has the both side fluctuation. Red thin line represents CALL option purchased at a strike price of $600.00 for $35.00. Black thick line represents portfolio of stock and CALL option were the profit from upside is limited (capped).
Therefore,
Maximum loss = $485.00 (being $520 - $35)
Maximum profit = $115.00 (being capped ($600 - $520) + $35)
Break-even (i.e., equilibrium) = $485.00 (being $520 - $35)
Advantage of doing this strategy:
To generate short term cash inflow by selling CALL option on regular basis. Also to achieve the target selling price if the market is static. Investor also reduces the effective cost of holding a share by writing a CALL option at the sacrifice of the upside return distribution.
Disadvantage of doing this strategy:
Investor runs the risk of regret i.e., opportunity cost if the stock price steeply rises and happens to be more then the strike price of $600.00. Basically investor are forgoing the right side of the return distribution. Also if the stock price crashes say to $300.00 or $200.00 levels, in such case investor have to offload the share at such levels and repent.
Recommendation to the investor:
If the investor has loads of funds (i.e., has no liquidity constraints) and expects the share price non-volatile then he can generate a short term income to reduce the cost of holding the shares.
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