Why Write A Covered Call - Part Two: Doing The Math
...continued from "Part One."
Two Examples of Returns
The two examples in Table 1 (contact us at vloptions@valueline.com for a copy of Table 1) were taken from our Selected Options for Covered Call Writing on May 8, 2002. They help demonstrate our model’s logic and are typical of our recommended covered calls since they offer attractive but differing degrees of upside potential, return and downside protection.
The out-of-the-money September covered call on Orbital Sciences, with a strike price of $7.50, priced at $0.97, costs the investor $5.22 per share to establish (i.e. $6.19 to buy the stock minus the $0.97 premium received from writing the call).
This covered call offers the investor downside protection of 15.0% based on the fact that breakeven for this position is at the $5.22 level. If the stock rises to $7.50 or above, the investor reaps a profit of 44.0% (i.e. the difference between the $7.50 strike price and the $5.22 needed to establish the position).
If the stock stands still at $6.19, the investor still gets an annualized return of 57.0% over the 138-day period to the September expiration date.
The in-the-money January 2003 $5.00 covered call, priced at $2.32, offers a greater degree of downside protection since the stock would have to fall by 37.5%, to $3.87 before the investor would start to lose money.
Upside potential, however, is limited by the fact that the stock price is already above the strike price. Nevertheless, if the position is held to expiration and the stock ends up at or above the $5.00 strike price, the investor will still reap a substantial return of 29.2% (before commissions), which comes to 43.9% on an annualized basis.
CLICK HERE FOR THE FULL-SIZED TABLE
The Formulas
In Table 2, we show the formulas for the above calculations. You can get an excel version of this table by emailing us at vloptions@valueline.com.
Posted By: Value Line
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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