Hedging Stock Investments Using Low-Risk Options Strategies - Covered Call

Please note that this example is for educational purposes and uses a historical trade from March 2007

The most popular options strategy among all investors today is Covered Call Writing. The basic idea of this strategy is to hold a stock with a near-term outlook that shows the stock will remain stagnant at its current price. In this situation, an investor could create a “synthetic” dividend by selling one call option and receiving the premium for every 100 shares of the stock that they own.

For example, Figure 1 below is a fictitious trade involving the purchasing or holding of AT&T (T) at $39.19 on March 22, 2007 and the selling of a $40 July 2007 Call Option, paying the investor a premium of $1.15 or $115 for the entire option. The figure also illustrates the amount of gain or loss at different stock prices. This analysis does not take into account the $.355 dividend paid in July, but if it were included, it would be an additional $35.50 at each profit/loss breakdown.

Figure 1

Covered Call Writing provides the investor the ability to create cash flow by selling options and keeping the premiums. In the example above, the selling of the option creates a “synthetic” dividend of 2.93% for a four month holding period, or an annualized ”synthetic” dividend of 8.79%, in addition to any actual cash dividends that the company pays on their shares. However, there are two main downsides to this strategy. The first is that keeping the money invested in a not-so-promising stock for an extended period leaves the investor open to losses from holding a losing security. The second drawback is that this strategy caps the upside that an investor can experience from holding the stock. If the security would experience a sudden growth, the investor would not benefit because he would have to sell at the strike price of the call option.