Covered Call Trading Vs. Buy-Write Trading Part 1

Ask The Option Scientist

Chri

s Ebert, author of the popular option trading book “Show Me Your Options!” and frequent contributor of option related articles on zentrader.ca often receives questions from readers. Do you have a question for the Option Scientist? Email questions to optionscientist@zentrader.ca. Email addresses will not be published.

Question: I am a novice on options and beginning to learn and play covered calls now. It seems to me that when I buy and write a covered call, it is easier than having underlying stock and writing a call later. Can you explain to me more about how to set up a stop loss or initial price target at $ for a potential gain?

Thanks for sharing your precious experience and time to help people like me. –Hungle

Answer: It would be easy to give a simple answer, but that would require skipping over a number of important details. So the answer has been split into two parts: Today, in Part 1 of Covered Call Trading Vs. Buy-Write Trading, the difference between the two strategies is explored. Tomorrow, in Part 2 the similarities will be explained, including stop losses and price targets.

Covered calls can be opened two different ways:

A call option can be sold when a trader owns at least 100 shares of stock (10 shares if using the new mini options). The process of selling an option technically requires that a contract be written and then offered for sale on an options exchange. However, over the years the process has become automated. Nowadays a contract can be written electronically. Still, the term “write” is often used to describe the selling process. While it is somewhat confusing, selling a call option is also known as writing a call option. When a trader already owns the required number of shares of stock (100 for a standard call option or 10 for a mini call option) selling a call option is known as either selling a Covered Call or writing a Covered Call.

A call option can be sold at the same time a trader purchases 100 shares of stock (10 shares if using the new mini options). This is also known as selling a Covered Call or writing a Covered Call. But because the process of buying the stock is done at the same time that the call option is sold, many use the term “Buy-Write” to distinguish it from a trade in which the stock is purchased prior to the call option being sold.

Although there is no difference between a covered call that is opened on previously-purchased stock and a covered call that is opened as a buy-write, there can be a major difference in the reason for opening the trade.

COVERED CALL SOLD ON STOCK THAT IS ALREADY OWNED

Let's start with the covered call on stock that is already owned. Say 100 shares of stock were purchased a few months ago at $40 per share, and the price steadily climbed higher and higher until it got to $50 per share. Recently though, over the past few weeks the price seems to have gotten stuck right around the $50 mark. That's what is known as resistance – traders who are attempting to push the stock price higher have found resistance at $50.

Resistance can sometimes signal a turning point for a stock, and the share price may subsequently fall considerably. Resistance can also mark a pause in trading, almost as if traders have bitten off more than they can chew. In these cases the stock price may move sideways for a time, as the previous gains are digested, followed by a resumption of the uptrend.

For a stock owner who believes the share price has hit “brick wall” resistance, that may represent an opportunity to just get out of the trade entirely – sell the stock and pocket the gains. After all, in an account with limited funds and so many other stocks to choose from, sitting on a stock that has hit a brick wall may not represent the best use of those funds. But a covered call can take advantage of resistance to generate income, thereby making better use of those funds.

Let's say the stock that was purchased at $40 in January is currently trading at $50 in May. While taking the $1000 gain on 100 shares can be tempting, selling a covered call may actually increase that gain. Of course the actual premium collected on a covered call will vary greatly from one stock to another depending on volatility, but in this example let's assume that a call can be sold at the $50 strike price, with June expiration, for a premium of $5 per share. One standard call option controls 100 shares of stock, so the total premium collected would be $500.

There are three possible outcomes:

ICING ON THE CAKE

Now when June rolls along, as long as the stock is still trading at $50 or higher, it will be sold for $50 (the strike price) when the call buyer exercises the option. The $1000 profit remains in place, plus the covered call seller gets to keep the $500 premium. In this scenario, the original profit of $1000 was increased to $1500 simply by selling a covered call.

HAVE YOUR CAKE AND EAT IT TOO

Unfortunately, the additional profit is not a guarantee. It is quite possible that the stock price could fall after hitting resistance. Assuming the stock price fell to $45 in June, the call option would expire worthless. As always, the covered call seller gets to keep the pr

emium, in this case $500. Although the profit on the stock would have decreased considerably, it could still be sold at a $500 profit, and with the added $500 premium from the covered call, the total profit on the trade would be $1000.

That's no better off than if the stock had just been sold in May, but it does present an additional opportunity. Once the call option has expired worthless, the covered call seller is under no obligation to sell the stock. If the decline in the stock price to $45 in June from its $50 high in May is simply due to the effect of “digestion” of the previous gains, it could be a great time to be a stock owner. Post-digestion rallies can be impressive, and it is possible that the stock could push past its previous $50 resistance level. In this scenario, selling the covered call on previously-owned stock allowed the stockholder to ride out the digestion period without giving back any gains, and keep the stock for a possible post-digestion rally.

LEFTOVER CRUMBS

It is entirely possible for the stock price to fall far enough to eat up no only the profits from a covered call, but also the unrealized gains on the stock itself. If the stock ends up trading at $35 in June, it is true that the covered call seller would keep the $500 profit when the call expired worthless. However, with the stock trading below the purchase price, selling it would result in a $500 loss. When combined with the $500 gain on the call option, the net trade becomes a total wash.

Which dessert is best? Well…nobody want's crumbs, so throw that one out! Icing on the cake is nice. But it can be argued that having your cake and eating it too is actually preferable. That's because whatever method of fundamental or technical analysis the trader employed in making the decision to sell the covered call, the analysis was correct. The trader has proven to have a good handle on this stock, and that may allow the trader to continue to profit from this stock in the future. On the other hand, as nice as it is to have icing on the cake, it proves that the trader's analysis was flawed. The trader does not have a good handle on this stock, and is less likely to profit on this stock in the future.

Given the possible outcomes, a covered call sold on stock that is already owned is most advantageous when it is observed that the STOCK HAS HIT RESISTANCE and is expected to either trade sideways for a time, or to experience a minor pullback in price followed by a resumption of the uptrend.

COVERED CALL SOLD AT THE SAME TIME THE STOCK IS PURCHASED (BUY-WRITE)

While it is possible to use a buy-write trade to earn profits from a stock that is moving sideways or declining in price, it is not an optimal use of the strategy.

For example, if 100 shares of a stock are purchased at $50 and a call option is sold at the $50 strike price for a premium of $5 per share, the trade will result in a profit at expiration as long as the share price does not fall below $45. Assuming the price did fall to $45, that wouldn't necessarily be such a bad thing. The call option would eventually expire worthless and the covered call seller would be left with the stock at a bargain cost basis of $45 – no gain, no loss. But in that scenario it would have been much simpler to avoid the covered call altogether and just buy 100 shares of stock when it fell to the “bargain” price of $45. Since there is no loss, this is a GOOD OUTCOME.

In a case where the stock was trading sideways at $50, the $5 per share premium on the covered call would eventually return a profit of $500. However, profits are the result of time decay eating up the value of the call option. To a covered call seller on a sideways-trading stock, time decay can feel like it is moving at a glacial pace. Earning the entire $500 profit sometimes requires holding the trade open until expiration day; and that amount of holding time can be unpleasantly long when a stock is trading sideways. Since there is a gain, this is a BETTER OUTCOME.

The same covered call opened when the stock was in a strong uptrend will ultimately return the same $500 profit as one that was opened when the stock was moving sideways. But the profit will tend to occur much more quickly in an uptrend. That means it is often possible to get out of the trade early, take the $500 (or most of the $500) and run! Since the gain occurred quickly, this is the BEST OUTCOME.

Given the possible outcomes, a covered call sold at the same time a stock is purchased, known as a “buy-write”, is most advantageous when it is expected that the STOCK IS UNLIKELY TO ENCOUNTER RESISTANCE in an uptrend.

Resistance can provide a distinct advantage for a covered call sold against previously-purchased stock, while the absence of resistance provides an advantage for a covered call opened as a buy-write. That's quite a difference!

More on “Covered Call Trading Vs. Buy-Write Trading” tomorrow, in part 2…