“Free” Covered Call Writes (09:17)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 9, No. 17 on September 14, 2000. 

Covered call writing is not a subject that we often discuss in this newsletter. There are several reasons for that, which we’ll get into in just a moment. However, there is a certain type of covered call write – one in which the call is quite expensive – that sometimes attracts traders looking for a “free ride.” To a certain extent, this strategy is something of a free ride. As you might imagine, though, there can be major problems (we’re still looking for that illusory free lunch on Wall Street, but haven’t ever been able to find it).

First, let’s provide some background information, including our reluctance about the covered writing strategy, in general. Many relatively novice traders are attracted by covered call writing, because the strategy involves stock ownership – and that’s something that they understand. In addition, brokers tend to like the strategy for that reason and for the reason that it generates turnover in stocks, or at least their options. Neither of those reasons should matter much to an option strategist, though, for he is looking for probabilities of making a good return on his money. As a strategy, COVERED call writing has nearly all the downside risks of common stock ownership, but not nearly all of the profit potential – since the profitability is limited above the striking price of the written call. Still, the covered writer can earn a superior return if the stock is relatively stable – remaining near the strike price of the call. What one has to assess, in order to determine if this is a “good” strategy or not, is the probability of the stock remaining relatively stable vs. that of the stock making a move. Most of the time, this strategy does not stand up to the “probability” test.

It should also be pointed out that naked put selling and covered call writing are equivalent strategies – they have the same profitability: large downside risks, and limited profit potential on the upside. Usually the sale of a naked put is a more efficient strategy than the covered write because of the smaller commission and investment costs involved. We are not going to get into an extended comparison of the two strategies in this article, though.

Rather, what we want to look at is a particular type of covered call write – one in which the investment is very nearly zero dollars. The investment required for a covered call write on margin is 50% of the stock price, less the proceeds received from selling the call.

In a margin account, in theory, it is possible for the option to sell for more than 50% of the stock cost. Hence, a covered write could be established for “free.” Let’s discuss this in terms of two types of calls: the in-the-money call write and the out-of-the-money call write.

Out-of-the-money Covered Call Write

This is the simplest way to approach the strategy. You may be able to find LEAPS options that are just slightly out-of-the-money, which sell for 50% of the stock price. Understandably, such a stock would be quite volatile.
Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a 2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for this covered write would be $0, although some commission costs would be involved. Your debit balance would be $19 points per share – the amount the broker loans you on margin.

Certain brokerage firms might require some sort of minimum margin deposit, but technically there is no further requirement for this position. Of course, your leverage is infinite. Suppose you decided to buy 10,000 shares of GOGO and sell 100 calls, covered. Your risk is $190,000 if the stock falls to zero! That also happens to be your debit balance in your account. Thus, for a minimal investment, you could lose a fortune. In addition, if the stock begins to fall, your broker is going to want maintenance margin. He probably wouldn’t let the stock slip more than a couple of points before asking for margin. If you own 10,000 shares and the broker wants two points maintenance margin, that means you’ll have to come up with $20,000.

Your profits wouldn’t be as big as they might at first seem. Your maximum gross profit potential is $210,000 if the 10,000 shares are called away at 40. You make 21 points on each share – the $40 sale price less your original cost of $19. However, you will have had to pay interest on the debit balance of $190,000 for two years. At 10%, say, that’s a total of $38,000. There would also be commissions on the purchase and the sale.
In summary, this is a position with tremendous – even dangerous – leverage.

In-The-Money Covered Call Write

The situation is slightly different if the option is in-themoney to begin with. The above margin requirements actually don’t quite accurately state the case for a margined covered call write. When a covered call is written against the stock, there is a “catch”: only 50% of the stock price or the strike price, whichever is less, is available for “release”. Thus, you will actually be required to put up more than 50% of the stock price to begin with.

Example: XYZ is trading at 50, and there is 2-
year LEAPS call with a strike price of 30, selling
for 25 points. You might think that the requirement
for a covered call write would be 0 since the
call sells for 50% of the stock price. But that’s
not the case with in-the-money covered calls.
Margin Requirement:
Buy stock 50 points
Less option proceeds –25
Less margin release* –15*
Net Requirement: 10 points
*: 50% of the strike price or 50% of stock price,
whichever is less.

This position still has a lot of leverage: you invest 10 points in hopes of making 20, if the stock is called away at 30. You also would have to pay interest on the 15-point debit balance of course, for the two-year duration of the position. Furthermore, should the stock fall below the strike price, the broker would begin to require maintenance margin.

Note that the above “formula” for the net requirement works equally well for the out-of-the-money covered call write, since 50% of the stock price is always less than 50% of the strike price in that case.

Summary
If you should decide to use this strategy, be extremely aware of the dangers of high leverage. Do not risk more money than you can afford to lose, regardless of how small the initial investment might be. Also, you must plan for some method of being able to make the margin payments along the way. Finally, the in-the-money alternative is probably best, because there is less probability that maintenance margin will be asked for.

This article was originally published in The Option Strategist Newsletter Volume 9, No. 17 on September 14, 2000.