It's been a while since we've looked at the covered call position, but the recent market correction provides a good time to use this strategy as a way to buy stocks at an even steeper discount to current prices and reduce the volatility of your portfolio.
Despite the fact that the VIX, which measures the implied volatility of S&P 500 index options, remains stubbornly stuck near eight-year lows, the sharp selloff in some individual names has prompted the implied volatilities of their related options to rise to their highest levels in nearly a year, making the sale of option premiums attractive. The covered call is popular because it's a straightforward concept strategically aligned with the natural bias toward stock ownership while being relatively simple to execute. Covered calls will lower your overall risk/reward profile but still leave room for substantial short-term gains. They also offer a simpler alternative to some of last week's strategies for a sideways market. Remember, the covered call is most effective when applied to stocks with prices that remain constant or rise in a slow and steady fashion. Here's a quick example of the basic covered call position: a long position in 1,000 shares of XYZ trading at $49, while selling 10 XYZ calls with a $50 strike for $1 a contract. As a hybrid position combining both the underlying security and offsetting option, it has a reduced risk/reward profile when compared to being either outright long the stock or just short the call.
Equal but Not the Same
To qualify as a valid covered call, both the stock and the option must be in the same account, the long stock must be the same underlying security specified by the short option, and you must hold at least enough shares of stock to fulfill the delivery requirement of the call option. These criteria are important because they determine in what type of account the position can be established, as well as the margin and maintenance requirements.