A covered call is a strategy, which is to sell a call option at the same time as you own the underlying asset. For example, if the investor expects the price of Novo Nordisk B to remain unchanged or rise slightly, the strategy of employing a covered call could be used to hedge the investor’s portfolio of shares. If the investor issues (sells) call options he will get the premium as an additional income and may thus increase the yield on the portfolio.
Another scenario could see an investor holding 500 shares in Novo Nordisk B, while wishing to improve the yield during a period when the price is expected to remain at the present level. The investor thus issues five call option contracts, each containing 100 underlying shares. The strike price of the options is 220 with expiry on 18 June. The premium is DKK 10 per share.
Income from the premium will thus be:
5 x 10 x 100 = 5,000
The figure shows the capital gain and loss upon expiration of the options for the portfolio of shares with and without covered call.
Please note that the investor makes a profit on the call options he has sold if the price of the share falls or remains unchanged and suffers a loss if the price rises above the strike price. However, the gain is limited to the premium received. Thus, the strategy cannot completely prevent a loss on the portfolio of shares in connection with major drops in share prices. The strategy covered call aims at pursuing the strategy until expiration.
However, this does not prevent the investor from changing his strategy if his expectations alter. A covered call strategy may also be used if the investor expects the share price to stabilise (falling volatility). This is due to the fact that the price of the option decreases when the fluctuations in the share price decrease.
If the investor expects the volatility in the share to fall, he should choose a strike price close to the existing share price, as the sensitivity of the option premium to changes in the volatility is the strongest around at-the-money. Likewise, if the investor has a strong feeling that the price of the shares is going to fall slightly, he should choose a low strike price, as the sensitivity of the call option increases when the strike price is reduced.
