Covered Calls

A “Buy-Write” strategy, also called a “covered call”, is an investment  strategy in which the investor buys a stock or a basket of  stocks and writes (or sells) call options that cover the stock position.  The strategy can be used to enhance portfolio returns  under certain market conditions and to reduce volatility. In down  markets, the option premium received cushions the price decline  in an equity portfolio. The trade-off is that in strong equity markets,  the upside potential of the equity investment is truncated  as the option is exercised above the strike price. A buy-write  strategy is often expected to outperform a purely passive stock index strategy in bear markets and underperform the purely passive  stock index in bull markets.

The above chart showing the Profit/Loss for a covered call on an S&P 500 basket of stocks known as the BXM (similar charts would apply to covered calls on individual stocks).  This illustration assumes that the option premium is $20 and that the strike price is 1300.  As you can see from the chart, the investment return is positive unless the S&P declines below $1280. 

If we knew the probability distribution for the S&P for the time duration of this option, we could compute the expected profit or loss and compare this with other investing opportunities, such as just buying and holding the S&P basket of stocks, buying and holding other stocks, doing a covered call on the S&P for other strike prices and or different expiration durations (with different premiums), as well as many other investment strategies.

As an aside, the historical performance of a covered call on the CBOE BXM was slightly better than purchasing and holding the BXM itself, with significantly less variance (which many people equate to risk).




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