This requires a relatively considerable investment for one position for the
individual investor. However, one should be aware that buying too few shares for cov
ered writing purposes can lower returns considerably.
Example: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call
for 3, his return if exercised would drop from the 11.2% return (cash) that was com
puted earlier to a return of9.9% in a cash account. Table 2-13 verifies this statement.
Since commissions are less, on a per-share basis, when one buys more stock and
sells more calls, the returns will naturally be higher with a 500- or 1,000-share posi
tion than with a 100- or 200-share position. This difference can be rather dramatic, as
Tables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be
drawn from these tables. The first and most obvious conclusion is that the rrwre shares
TABLE 2-13.
Cash investment vs. return.
Net Investment-Cash ( l 00 shares)
Stock cost $4,300
Plus commissions + 85
Less option premium 300
Plus option commissions + 25
Net investment $4,110
Return If Exercised-Cash ( l 00 shares)
Stock sale price
Stock commissions
Plus dividend
Less net investment
Net profit if exercised
$4,500
85
+ 100
- 4 110
$ 405
Return if exercised = $4 05 = 9. 9%
$4,110
Cl,apter 2: Covered Call Writing 55
one writes against, the higher his returns and the lower his break-even point will be.
This is true for both cash and margin and is a direct result of the way commissions are
figured: Larger trades involve smaller percentage commission charges. While the per
centage returns increase as the number of shares increases for both cash and margin
covered writing, the increase is much more dramatic in the case of margin. Note that
in Table 2-14, which depicts cash transactions, the return from writing against 100
shares is 9.9% and increases to 12. 7% if 2,000 shares are written against. This is an
increase, but not a particularly dramatic one. However, in Table 2-15, the return if
exercised more than doubles (21.6 vs. 10.4) and the return if unchanged nearly triples
(13.0 vs. 4.4) when the 100-share write is compared to the 2,000-share write. This
effect is more dramatic for margin writes due to two factors - the lower investment
required and the more burdensome effect of margin interest charges on the profits of
smaller positions. This effect is so dramatic that a 100-share write in a cash account in
our example actually offers a higher return if unchanged than does the margin write
- 7.1 % vs. 4.4%. This implies that one should carefully compute his potential returns
if he is writing against a small number of shares on margin.
TABLE 2-14.
Cash covered writes (costs included).
Shares Written Against
100 200 300 400 500 1,000 2,000
Return if exercised (%) 9.9 10.0 10.4 10.8 11.2 12.1 12.7
Re~rn if unchanged(%) 7.1 7.2 7.5 7.7 7.9 8.4 8.7
Break-even point 40.1 40.0 39.9 39.9 39.8 39.6 39.5
TABLE 2-15.
Margin covered writes (costs included).
Shares Written Against
100 200 300 400 500 1,000 2,000
Return if exercised (%) 10.4 15.8 16.6 17.4 18.4 20.4 21.6
Return if unchanged (%) 4.4 9.8 10.3 10.8 11.4 12.3 13.0
Break-even point 41.2 41.1 41.0 41.0 40.9 40.7 40.6
WHAT A DIFFERENCE A DIME MAKES
Another aspect of covered writing that can be important as far as potential returns
are concerned is, of course, the prices of the stock and option involved in the write.
56 Part II: Call Option Strategies
It may seem insignificant that one has to pay an extra few cents for the stock or pos
sibly receives a dime or 20 cents less for the call, but even a relatively small fraction
can alter the potential returns by a surprising amount. This is especially true for in
the-money writes, although any write will be affected. Let us use the previous 500-
share covered writing example, again including all costs.
As before, the results are more dramatic for the margin write than for the cash
write. In neither case does the break-even point change by much. However, the
potential returns are altered significantly. Notice that if one pays an extra dime for
the stock and receives a dime less for the call - the far right-hand column in Table
2-16 - he may greatly negate the effect of writing against a larger number of shares.
From Table 2-16, one can see that writing against 300 shares at those prices (43 for
the stock and 3 for the call) is approximately the same return as writing against 500
shares if the stock costs 431/s and the option brings in 27/s.
Table 2-16 should clearly demonstrate that entering a covered writing order at
the market may not be a prudent thing to do, especially if one's calculations for the
potential returns are based on last sales or on closing prices in the newspaper. In the
next section, we discuss in depth the proper procedure for entering a covered writ
ing order.
TABLE 2-16.
Effect of stock and option prices on writing returns.
Buy Stock at 43 Buy Stock at 43.10
Sell Call at 3 Sell Call at 3
Return if exercised 11.2% cash 10.9% cash
18.4% margin 17.7% margin
Return if unchanged 7.9% cash 7.6% cash
11 .4% margin 10.7% margin
Break-even point 39.8 cash 39.9 cash
40.9 margin 41.0 margin
EXECUTION OF THE COVERED WRITE ORDER
Buy Stock at 43. I 0
Sell Call at 2.90
10.6% cash
16. 9% margin
7.3% cash
9.9% margin
40.0 cash
41.1 margin
When establishing a covered writing position, the question often arises: Which
should be done first - buy the stock or sell the option? The correct answer is that nei
ther should be done first! In fact, a simultaneous transaction of buying the stock and
selling the option is the only way of assuring that both sides of the covered write are
established at desired price levels.
Cl,apter 2: Covered Call Writing 57
If one "legs" into the position - that is, buys the stock first and then attempts to
sell the option, or vice versa - he is subjecting himself to a risk.


uld be done first! In fact, a simultaneous transaction of buying the stock and
selling the option is the only way of assuring that both sides of the covered write are
established at desired price levels.
Cl,apter 2: Covered Call Writing 57
If one "legs" into the position - that is, buys the stock first and then attempts to
sell the option, or vice versa - he is subjecting himself to a risk.
Example: An investor wants to buy XYZ at 43 and sell the July 45 call at 3. Ifhe first
sells the option at 3 and then tries to buy the stock, he may find that he has to pay
more than 43 for the stock. On the other hand, if he tries to buy the stock first and
then sell the option, he may find that the option price has moved down. In either case
the writer will be accepting a lower return on his covered write. Table 2-16 demon
strated how one's returns might be affected ifhe has to give up an eighth by "legging"
into the position.
ESTABLISHING A NET POSITION
What the covered writer really wants to do is ensure that his net price is obtained. If
he wants to buy stock at 43 and sell an option at 3, he is attempting to establish the
position at 40 net. He normally would not mind paying 43.10 for the stock if he can
sell the call at 3.10, thereby still obtaining 40 net.
A "net" covered writing order must be placed with a brokerage firm because it
is essential for the person actually executing the order to have full access to both the
stock exchange and the option exchange. This is also referred to as a contingent
order. Most major brokerage firms offer this service to their clients, although some
place a minimum number of shares on the order. That is, one must write against at
least 500 or 1,000 shares in order to avail himself of the service. There are, however,
brokerage firms that will take net orders even for 100-share covered writes. Since the
chances of giving away a dime are relatively great if one attempts to execute his own
order by placing separate orders on two exchanges - stock and option - he should
avail himself of the broker's service. Moreover, if his orders are for a small number of
shares, he should deal with a broker who will take net orders for small positions.
The reader must understand that there is no guarantee that a net order will be
filled. The net order is always a "not held" order, meaning that the customer is not
guaranteed an execution even if it appears that the order could be filled at prevailing
market bids and offers. Of course, the broker will attempt to fill the order if it can
reasonably be accomplished, since that is his livelihood. However, if the net order is
slightly away from current market prices, the broker may have to "leg" into the posi
tion to fill the order. The risk in this is the broker's responsibility, not the customer's.
Therefore, the broker may elect not to take the risk and to report "nothing done" -
the order is not filled.
If one buys stock at 43 and sells the call at 3, is the return really the same as buy
ing the stock at 43.10 and selling the call at 3.10? The answer is, yes, the returns are
58 Part II: Call Option Strategies
very similar when the prices differ by small amounts. This can be seen without the
use of a table. If one pays a dime more for the stock, his investment increases by $10
per 100 shares, or $50 total on a 500-share transaction. However, the fact that he has
received an extra dime for the call means that the investment is reduced by $62.50.
Thus, there is no effect on the net investment except for commissions. The commis
sion on 500 shares at 43.10 may be slightly higher than the commission for 500 shares
at 43. Similarly, the commission on 5 calls at 3.10 may be slightly higher than that on
5 calls at 3. Even so, the increase in commissions would be so small that it would not
affect the return by more than one-tenth of 1 %.
To carry this concept to extremes may prove somewhat misleading. If one were
to buy stock at 40½ and sell the call at ½, he would still be receiving 40 net, but sev
eral aspects would have changed considerably. The return if exercised remains amaz
ingly constant, but the return if unchanged and the percentage downside protection
are reduced dramatically. If one were to buy stock at 48 and sell the call at 8 - again
for 40 net - he would improve the return if unchanged and the percentage downside
protection. In reality, when one places a "net" order with a brokerage firm, he nor
mally gets an execution with prices quite close to the ones at the time the order was
first entered. It would be a rare case, indeed, when either upside or downside
extremes such as those mentioned here would occur in the same trading day.
SELECTING A COVERED WRITING POSITION
The preceding sections, in describing types of covered writes and how to compute
returns and break-even points, have laid the groundwork for the ultimate decision
that every covered writer must make: choosing which stock to buy and which option
to write. This is not necessarily an easy task, because there are large numbers of
stocks, striking prices, and expiration dates to choose from.
Since the primary objective of covered writing for most investors is increased
income through stock ownership, the return on investment is an important consider
ation in determining which write to choose. However, the decision must not be made
on the basis of return alone. More volatile stocks will offer higher returns, but they
may also involve more risk because of their ability to fall in price quickly. Thus, the
amount of downside protection is the other important objective of covered writing.
Finally, the quality and technical or fundamental outlook of the underlying stock
itself are of importance as well. The following section will help to quantify how these
factors should be viewed by the covered writer.
Chapter 2: Covered Call Writing
PROJECTED RETURNS
59
The return that one strives for is somewhat a matt

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


ownside protection is the other important objective of covered writing.
Finally, the quality and technical or fundamental outlook of the underlying stock
itself are of importance as well. The following section will help to quantify how these
factors should be viewed by the covered writer.
Chapter 2: Covered Call Writing
PROJECTED RETURNS
59
The return that one strives for is somewhat a matter of personal preference. In gen
eral, the annualized return if unchanged should be used as the comparative measure
between various covered writes. In using this return as the measuring criterion, one
does not make any assumptions about the stock moving up in price in order to attain
the potential return. A general rule used in deciding what is a minimally acceptable
return is to consider a covered writing position only when the return if unchanged is
at least 1 % per month. That is, a 3-month write would have to offer a return of at
least 3% and a 6-month write would have to have a return if unchanged of at least
6%. During periods of expanded option premiums, there may be so many writes that
satisfy this criterion that one would want to raise his sights somewhat, say to 1 ½% or
2% per month. Also, one must feel personally comfortable that his minimum return
criterion - whether it be 1 % per month or 2% per month - is large enough to com
pensate for the risks he is taking. That is, the downside risk of owning stock, should
it fall far enough to outdistance the premium received, should be adequately com
pensated for by the potential return. It should be pointed out that 1 % per month is
not a return to be taken lightly, especially if there is a reasonable assurance that it can
be attained. However, if less risky investments, such as bonds, were yielding 12%
annually, the covered writer must set his sights higher.
Normally, the returns from various covered writing situations are compared by
annualizing the returns. One should not, however, be deluded into believing that he
can always attain the projected annual return. A 6-month write that offers a 6%
return annualizes to 12%. But if one establishes such a position, all that he can
achieve is 6% in 6 months. One does not really know for sure that 6 months from now
there will be another position available that will provide 6% over the next 6 months.
The deeper that the written option is in-the-money, the higher the probability
that the return if unchanged will actually be attained. In an in-the-money situation,
recall that the return if unchanged is the same as the return if exercised. Both would
be attained unless the stock fell below the striking price by expiration. Thus, for an in
the-money write, the projected return is attained if the stock rises, remains unchanged,
or even falls slightly by the time the option expires. Higher potential returns are avail
able for out-of-the-money writes if the stock rises. However, should the stock remain
the same or decline in price, the out-of-the-money write will generally underperform
the in-the-money write. This is why the return if unchanged is a good comparison.
DOWNSIDE PROTECTION
Downside protection is more difficult to quantify than projected returns are. As men
tioned earlier, the percentage of downside protection is often used as a measure. This
60 Part II: Call Option Strategies
is somewhat misleading, however, since the more volatile stocks will always offer a
large percentage of downside protection (their premiums are higher). The difficulty
arises in trying to decide if 10% protection on a volatile stock is better than or worse
than, say, 6% protection on a less volatile stock. There are mathematical ways to
quantify this, but because of the relatively advanced nature of the computations
involved, they are not discussed until later in the text, in Chapter 28 on mathemati
cal applications.
Rather than go into involved mathematical calculations, many covered writers
use the percentage of downside protection and will only consider writes that offer a
certain minimum level of protection, say 10%. Although this is not exact, it does
strive to ensure that one has minimal downside protection in a covered write, as well
as an acceptable return. A standard figure that is often used is the 10% level of pro
tection. Alternatively, one may also require that the write be a certain percent in-the
money, say 5%. This is just another way of arriving at the same concept.
THE IMPORTANCE OF STRATEGY
In a conservative option writing strategy, one should be looking for minimum returns
if unchanged of 1 % per month, with downside protection of at least 10%, as general
guidelines. Employing such criteria automatically forces one to write in-the-money
options in line with the total return concept. The overall position constructed by
using such guidelines as these will be a relatively conservative position - regardless
of the volatility of the underlying stock - since the levels of protection will be large
but a reasonable return can still be attained. There is a danger, however, in using
fixed guidelines, because market conditions change. In the early days of listed
options, premiums were so large that virtually every at- or in-the-money covered
write satisfied the foregoing criteria. However, now one should work with a ranked
list of covered writing positions, or perhaps two lists. A daily computer ranking of
either or both of the following categories would help establish the most attractive
types of conservative covered writes. One list would rank, by annualized return, the
writes that afford, as a minimum, the desired downside protection level, say 10%.
The other list would rank, by percentage downside protection, all the writes that
meet at least the minimum acceptable return if unchanged, say 12%. If premium lev
els shrink and the lists become quite small on a daily basis, one might consider
expanding the criteria to view more potential situations. On


rn, the
writes that afford, as a minimum, the desired downside protection level, say 10%.
The other list would rank, by percentage downside protection, all the writes that
meet at least the minimum acceptable return if unchanged, say 12%. If premium lev
els shrink and the lists become quite small on a daily basis, one might consider
expanding the criteria to view more potential situations. On the other hand, if pre
miums expand dramatically, one might consider using more restrictive criteria, to
reduce the number of potential writing candidates.
A different group of covered writers may favor a more aggressive strategy of out
of-the-money writes. There is some mathematical basis to believe, in the long rnn, that
Chapter 2: Covered Call Writing 61
rrwderately out-of the-rrwney covered writes will peiform better than in-the-rrwney
writes. In falling or static markets, any covered writer, even the more aggressive one,
will outperform the stockowner who does not write calls. The out-of-the-money cov
ered writer has more risk in such a market than the in-the-money writer does. But in
a rising market, the out-of-the-money covered writer will not limit his returns as much
as the in-the-money writer will. As stated earlier, the out-of-the-money writer's per
formance will more closely follow the performance of the underlying stock; that is, it
will be more volatile on a quarter-by-quarter basis.
There is merit in either philosophy. The in-the-money writes appeal to those
investors looking to earn a relatively consistent, moderate rate of return. This is the
total return concept. These investors are generally concerned with preservation of
capital, thus striving for the greater levels of downside protection available from in
the-money writes. On the other hand, some investors prefer to strive for higher
potential returns through writing out-of-the-money calls. These more aggressive
investors are willing to accept more downside risk in their covered writing positions
in exchange for the possibility of higher returns should the underlying stock rise in
price. These investors often rely on a bullish research opinion on a stock in order to
select out-of-the-money writes.
Although the type of covered writing strategy pursued is a matter of personal
philosophy, it would seem that the benefits of in-the-money strategy- more consis
tent returns and lessened risk than stock ownership will normally provide - would
lead the portfolio manager or less aggressive investor toward this strategy. If the
investor is interested in achieving higher returns, some of the strategies to be pre
sented later in the book may be able to provide higher returns with less risk than can
out-of-the-money covered writing.
The final important consideration in selecting a covered write is the underlying
stock itself. One does not necessarily have to be bullish on the underlying stock to
take a covered writing position. As long as one does not foresee a potential decline in
the underlying stock, he can feel free to establish the covered writing position. It is
generally best if one is neutral or slightly bullish on the underlying stock. If one is
bearish, he should not take a covered writing position on that stock, regardless of the
levels of protection that can be obtained. An even broader statement is that one
should not establish a covered write on a stock that he does not want to own. Some
individual investors may have qualms about buying stock they feel is too volatile for
them. Impartially, if the return and protection are adequate, the characteristics of the
total position are different from those of the underlying stock. However, it is still true
that one should not invest in positions that he considers too risky for his portfolio, nor
should one establish a covered write just because he likes a particular stock. If the
62 Part II: Call Option Strategies
potential return is unchanged or levels of downside protection do not meet one's cri
teria, the write should not be established.
The covered writing strategist strives for a balance between acceptable returns
and downside protection. He rejects situations that do not meet his criteria in either
category and rejects stocks on which he is bearish. The resulting situations will prob
ably fulfill the objectives of a conservative covered writing program: increased income,
protection, and less variability of results on a less volatile investment portfolio.
WRITING AGAINST STOCK ALREADY OWNED
Establishing covered writing positions against stock that has previously been pur
chased involves other factors. It is often the case that an investor owns stock that
has listed options trading, but feels that the returns from writing are too low in
comparison to other covered writes that simultaneously exist in the marketplace.
This opinion may be valid, but often arises from the fact that the investor has seen
a computer-generated list showing returns on his stock as being low in comparison
to similarly priced stocks. One should note that such lists generally assume that
stock is bought in order to establish the covered write; the returns are usually not
computed and published for writing against stock already held. It may be the case
that the commission costs for selling one stock and investing in another may alter
the returns so substantially that one would be better off to write against the shares
of stock initially held.
Example: An investor owns XYZ stock and is comparing it against AAA stock for
writing purposes. If AAA is more volatile than XYZ, the current prices might appear
as follows:
Stock
XYZ: 50
AAA:50
Oct 50 Coll
4
6
Table 2-17 summarizes the computation of the return if exercised as one might
see it listed on a daily or weekly summary of available covered writing returns.
Assume that 500 shares are being written against, that XYZ will pay 50 cents per
share in dividends while AAA pays none during the life of


than XYZ, the current prices might appear
as follows:
Stock
XYZ: 50
AAA:50
Oct 50 Coll
4
6
Table 2-17 summarizes the computation of the return if exercised as one might
see it listed on a daily or weekly summary of available covered writing returns.
Assume that 500 shares are being written against, that XYZ will pay 50 cents per
share in dividends while AAA pays none during the life of the call, and that the
October 50 is a 6-month call.
Without going into as much detail, the other significant aspects of these two
writes are:
Chapter 2: Covered Call Writing
Return if exercised - margin
Downside break-even point cash
Downside break-even point - margin
XYZ
7.9%
46.3
47.6
63
AAA
16.2%
44.9
46.1
Seeing these calculations, the XYZ stockholder may feel that it is not advisable to
write against his stock, or he may even be tempted to sell XYZ and buy AAA in order
to establish a covered write. Either of these actions could be a mistake.
First, he should compute what his returns would be, at current prices, from
writing against the XYZ he already owns. Since the stock is already held, no stock buy
commissions would be involved. This would reduce the net investment shown below
by the stock purchase commissions, or $345, giving a total net investment (cash) of
$23,077. In theory, the stockholder does not really make an investment per se; after
all, he already owns the stock. However, for the purposes of computing returns, an
investment figure is necessary. This reduction in the net investment will increase his
profit by the same amount - $345 - thus, bringing the profit up to $1,828.
Consequently, the return if exercised (cash) wpuld be 7.9% on XYZ stock already
held. On margin, the return would increase to 11.3% after eliminating purchase com
missions. This return, assumed to be for a 6-month period, is well in excess of 1 % per
TABLE 2-17.
Summary of covered writing returns, XYZ and AAA.
XYZ AAA
Buy 500 shares at 50 $25,000 $25,000
Plus stock commissions + 345 + 345
Less option premiums received - 2,000 - 3,000
Plus option sale commissions + 77 + 91
Net investment-cash $23,422 $22,436
Sell 500 shares at 50 $25,000 $25,000
Less stock sale commissions 345 345
Dividend received + 250 0
Less net investment - 23,422 - 22,436
Net profit $ 1,483 $ 2,219
Return if exercised-cash 6.3% 9.9%
' 64 Part II: Call Option Strategies
month, the level nominally used for acceptable covered writes. Thus, the investor
who already owns stock may inadvertently be overlooking a potentially attractive cov
ered write because he has not computed the returns excluding the stock purchase
commission on his current stock holding.
It could conceivably be an even more extreme oversight for the investor to
switch from XYZ to AAA for writing purposes. The investor may consider making this
switch because he thinks that he could substantially increase his return, from 6.3% to
9.9% for the 6-month period, as shown in Table 2-17 comparing the two writes.
However, the returns are not truly comparable because the investor already
owns XYZ. To make the switch, he would first have to spend $345 in stock commis
sions to sell his XYZ, thereby reducing his profits on AAA by $345. Referring again to
the preceding detailed breakdown of the return if exercised, the profit on AAA would
then decline to $1,874 on the investment of $22,436, a return if exercised (cash) of
8.4%. On margin, the comparable return from switching stocks would drop to 14.8%.
The real comparison in returns from writing against these two stocks should be
made in the following manner. The return from writing against XYZ that is already
held should be compared with the return from writing against AAA after switching
fromXYZ:
Return if exercised - cash
Return if exercised - margin
XYZ Already Held
7.9%
11.3%
Switch from XYZ to AAA
8.4%
14.8%
Each investor must decide for himself whether it is worth this much smaller
increase in return to switch to a more volatile stock that pays a smaller dividend. He
can, of course, only make this decision by making the true comparison shown imme
diately above as opposed to the first comparison, which assumed that both stocks had
to be purchased in order to establish the covered write.
The same logic applies in situations in which an investor has been doing cov
ered writing. If he owns stock on which an option has expired, he will have to decide
whether to write against the same stock again or to sell the stock and buy a new stock
for covered writing purposes. Generally, the investor should write against the stock
already held. This justifies the method of computation of return if unchanged for out
of-the-money writes and also the computation of downside break-even points in
which a stock sale commission was not charged. That is, the writer would not nor
mally sell his stock after an option has expired worthless, but would instead write
another option against the same stock. It is thus acceptable to make these computa
tions without including a stock sales commission.
Chapter 2: Covered Call Writing
A WORD OF CAUTION
65
The stockholder who owns stock from a previous purchase and later contemplates
writing calls against that stock must be aware of his situation. He must realize and
accept the fact that he might lose his stock via assignment. If he is determined to
retain ownership of the stock, he may have to buy back the written option at a loss
should the underlying stock increase in price. In essence, he is limiting the stock's
upside potential. If a stockholder is going to be frustrated and disappointed when he
is not fully participating during a rally in his stock, he should not write a call in the
first place. Perhaps he could utilize the incremental return concept of covered writ
ing, a topic covered later in this chapter.
As stressed earlier, a covered writing strategy involves viewing the stock and
option as a total position. It is n


stockholder is going to be frustrated and disappointed when he
is not fully participating during a rally in his stock, he should not write a call in the
first place. Perhaps he could utilize the incremental return concept of covered writ
ing, a topic covered later in this chapter.
As stressed earlier, a covered writing strategy involves viewing the stock and
option as a total position. It is not a strategy wherein the investor is a stockholder who
also trades options against his stock position. If the stockholder is selling the calls
because he thinks the stock is going to decline in price and the call trade itself will be
profitable, he may be putting himself in a tenuous position. Thinking this way, he will
probably be satisfied only if he makes a profit on the call trade, regardless of the
unrealized result in the underlying stock. This sort of philosophy is contrary to a cov
ered writing strategy philosophy. Such an investor - he is really becoming a trader
should carefully review his motives for writing the call and anticipate his reaction if
the stock rises substantially in price after the call has been written.
In essence, writing calls against stock that you have no intention of selling is
tantamount to writing naked calls! If one is going to be extremely frustrated, perhaps
even experiencing sleepless nights, if his stock rises above the strike price of the call
that he has written, then he is experiencing trials and tribulations much as the writer
of a naked call would if the same stock move occurred. This is an unacceptable level
of emotional worry for a true covered writing strategist.
Think about it. If you have some very low-cost-basis stock that you don't really
want to sell, and then you sell covered calls against that stock, what do you wish will
happen? Most certainly you wish that the options will expire worthless (i.e., that the
stock won't get called away) - exactly what a naked writer wishes for.
The problems can be compounded if the stock rises, and one then decides to
roll these calls. Rather than spend a small debit to close out a losing position, an
investor may attempt to roll to more distant expiration months and higher strike
prices in order to keep bringing in credits. Eventually, he runs out of room as the
lower strikes disappear, and he has to either sell some stock or pay a big debit to buy
back the written calls. So, if the underlying stock continues to run higher, the writer
suffers emotional devastation as he attempts to "fight the market." There have been
some classic cases of Murphy's law whereby people have covered the calls at a big
66 Part II: Call Option Strategies
debit rather than let their "untouchable" stock be called away, just before the stock
itself or the stock market collapsed.
One should be very cautious about writing covered calls against stocks that he
doesn't intend to sell. If one feels that he cannot sell his stock, for whatever reason -
tax considerations, emotional ties, etc. - he really should not sell covered calls against
it. Perhaps buying a protective put ( discussed in a later chapter) would be a better
strategy for such a stockholder.
DIVERSIFYING RETURN AND PROTECTION
IN A COVERED WRITE
FUNDAMENTAL DIVERSIFICATION TECHNIQUES
Quite clearly, the covered writing strategist would like to have as much of a combina
tion of high potential returns and adequate downside protection as he can obtain.
Writing an out-of-the-money call will offer higher returns if exercised, but it usually
affords only a modest amount of downside protection. On the other hand, writing an
in-the-money call will provide more downside cushion but offers a lower return if
exercised. For some strategists, this diversification is realized in practice by writing
out-of-the-money calls on some stocks and in-the-moneys on other stocks. There is no
guarantee that writing in this manner on a list of diversified stocks will produce supe
rior results. One is still forced to pick the stocks that he expects will perform better
(for out-of-the-money writing), and that is difficult to do. Moreover, the individual
investor may not have enough funds available to diversify into many such situations.
There is, however, another alternative to obtaining diversification of both returns and
downside protection in a covered writing situation.
The writer may often do best by writing half of his position against in-the-rrwn
eys and half against out-of the-rrwneys on the same stock. This is especially attractive
for a stock whose out-of-the-money calls do not appear to provide enough downside
protection, and at the same time, whose in-the-money calls do not provide quite
enough return. By writing both options, the writer may be able to acquire the return
and protection diversification that he is seeking.
Example: The following prices exist for 6-month calls:
XYZ common stock, 42;
XYZ April 40 call, 4; and
XYZ April 45 call, 2.
Chapter 2: Covered Call Writing 67
The writer wishing to establish a covered write against XYZ common stock may like
the protection afforded by the April 40 call, but may not find the return particularly
attractive. He may be able to improve his return by writing April 45's against part of
his position. Assume the writer is considering buying 1,000 shares of XYZ. Table 2-18
compares the attributes of writing the out-of-the-money (April 45) only, or of writing
only the in-the-money (April 40), or of writing 5 of each. The table is based on a cash
covered write, but returns and protection would be similar for a margin write.
Commissions are included in the figures.
It is easily seen that the "combined" write - half of the position against the April
40's and the other half against the April 45's - offers the best balance of return and
protection. The in-the-money call, by itself, provides over 10% downside protection,
but the 5% return if exercised is less than 1 % per month. Thus, one migh


lar for a margin write.
Commissions are included in the figures.
It is easily seen that the "combined" write - half of the position against the April
40's and the other half against the April 45's - offers the best balance of return and
protection. The in-the-money call, by itself, provides over 10% downside protection,
but the 5% return if exercised is less than 1 % per month. Thus, one might not want
to write April 40's against his entire position, because the potential return is small. At
the same time, the April 45's, if written against the entire stock position, would pro
vide for an attractive return if exercised (over 2% per month) but offer only 5% down
side protection. The combined write, which has the better features of both options,
offers over 8% return if exercised (11h% per month) and affords over 8% downside
protection. By writing both calls, the writer has potentially solved the problems inher
ent in writing entirely out-of-the-moneys or entirely in-the-moneys. The "combined"
write frees the covered writer from having to initially take a bearish (in-the-money
write) or bullish (out-of-the-money write) posture on the stock ifhe does not want to.
This is often necessary on a low-volatility stock trading between striking prices.
TABLE 2-18.
Attributes of various writes.
Buy 1,000 XYZ and sell
Return if exercised
Re~rn if unchanged
Percent protection
In-the-Money
Write
10 April 40's
5.1%
5.1%
10.5%
Out-of-the-Money
Write
l O April 45's
12.2%
6.0%
5.7%
Write
Both Calls
5 April 40's and
5 April 45's
8.4%
5.4%
8.1%
For those who prefer a graphic representation, the profit graph shown in Figure
2-2 compares the combined write of both calls with either the in-the-money write or
the out-of-the-money write (dashed lines). It can be observed that all three choices
are equal if XYZ is near 42 at expiration; all three lines intersect there.
68 Part II: Call Option Strategies
FIGURE 2-2.
Comparison: combined write vs. in-the-money write and out-of-the
money write.
Out-of-the-Money Write
,
.-------► ,,, Combined Write ,
/ In-the-Money Write
-----------➔
Stock Price at Expiration
Since this technique can be useful in providing diversification between protec
tion and return, not only for an individual position but for a large part of a portfolio,
it may be useful to see exactly how to compute the potential returns and break-even
points. Tables 2-19 and 2-20 calculate the return if exercised and the return if
unchanged using the prices from the previous example. Assume XYZ will pay $1 per
share in dividends before April expiration.
Note that the profit calculations are similar to those described in earlier sec
tions, except that now there are two prices for stock sales since there are two options
involved. In the "return if exercised" section, half of the stock is sold at 45 and half is
sold at 40. The "return if unchanged" calculation is somewhat more complicated now,
TABLE 2-19.
Net investment-cash account.
Buy 1,000 XYZ at 42
Plus stock commissions
Less options premiums:
Sell 5 April 40's at 4
Sell 5 April 45's at 2
Plus total option commissions
Net investment
+
$42,000
460
- 2,000
1,000
+ 140
$39,600
Chapter 2: Covered Call Writing
TABLE 2-20.
Net return-cash account.
Return If Exercised
Sell 500 XYZ at 45 $22,500
Sell 500 XYZ at 40 20,000
Less total stock sale
commissions 560
Plus dividends ($1 /share) + 1,000
Less net investment - 39,600
Net profit if exercised $ 3,340
Return if exercised = 3,340 = 8_4%
(cash) 39,600
69
Return If Unchanged
Unchanged stock value (500
shares at 42) $21,000
Sell 500 at 40 + 20,000
Commissions on sale at 40 280
Plus dividends ($1 /share) . + 1,000
Less net investment - 39,600
Net profit if unchanged $ 2, 120
Return if unchanged = 2, 120 = 5 _4%
(cash) 39,600
because half of the stock will be called away if it remains unchanged (the in-the
money portion) whereas the other half will not. This is consistent with the method of
calculating the return if unchanged that was introduced previously.
The break-even point is calculated as before. The "total stock cost to expiration"
would be the net investment of $39,600 less the $1,000 received in dividends. This is
a total of $38,600. On a per-share basis, then, the break-even point of 38.6 is 8.1 %
below the current stock price of 42. Thus, the amount of percentage downside pro
tection is 8.1 %.
The foregoing calculations clearly demonstrate that the returns on the "com
bined" write are not exactly the averages of the in-the-money and out-of-the-money
returns, because of the different commission calculations at various stock prices.
However, if one is working with a computer-generated list and does not want to both
er to calculate exactly the return on the combined write, he can arrive at a relatively
close approximation by averaging the returns for the in-the-money write and the out
of-the-money write.
OTHER DIVERSIFICATION TECHNIQUES
Holders of large positions in a particular stock may want even more diversification
than can be provided by writing against two different striking prices. Institutions,
pension funds, and large individual stockholders may fall into this category. It is often
advisable for such large stockholders to diversify their writing over time as well as
over at least two striking prices. By diversifying over time - for example, writing one-
70 Part II: Call Option Strategies
third of the position against near-term calls, one-third against middle-term calls, and
the remaining third against long-term calls - one can gain several benefits. First, all
of one's positions need not be adjusted at the same time. This includes either having
the stock called away or buying back one written call and selling another. Moreover,
one is not subject only to the level of option premiums that exist at the time one
series of calls expires. For example, if one writes only 9-month calls and then


t long-term calls - one can gain several benefits. First, all
of one's positions need not be adjusted at the same time. This includes either having
the stock called away or buying back one written call and selling another. Moreover,
one is not subject only to the level of option premiums that exist at the time one
series of calls expires. For example, if one writes only 9-month calls and then rolls
them over when they expire, he may unnecessarily be subjecting himself to the
potential of lower returns. If option premium levels happen to be low when it is time
for this 9-month call writer to sell more calls, he will be establishing a less-than-opti
mum write for up to 9 months. By spreading his writing out over time, he would, at
worst, be subjecting only one-third of his holding to the low-premium write.
Hopefully, premiums would expand before the next eXpiration 3 months later, and he
would then be getting a relatively better premium on the next third of his portfolio.
There is an important aside here: The individual or relatively small investor who
owns only enough stock to write one series of options should generally not write the
longest-term calls for this very reason. He may not be obtaining a particularly attrac
tive level of premiums, but may feel he is forced to retain the position until expira
tion. Thus, he could be in a relatively poor write for as long as 9 months. Finally, this
type of diversification may also lead to having calls at various striking prices as· the
market fluctuates cyclically. All of one's stock is not necessarily committed at one
price if this diversification technique is employed.
This concludes the discussion of how to establish a covered writing position
against stock. Covered writes against other types of securities are described later.
FOLLOW-UP ACTION
Establishing a covered write, or any option position for that matter, is only part of the
strategist's job. Once the position has been taken, it must be monitored closely so that
adjustments may be made should the stock drop too far in price. Moreover, even if
the stock remains relatively unchanged, adjustments will need to be made as the writ
ten call approaches expiration.
Some writers take no follow-up action at all, preferring to let a stock be called
away if it rises above the striking price at the expiration of the option, or preferring
to let the original expire worthless if the stock is below the strike. These are not
always optimum actions; there may be much more decision making involved.
Follow-up action can be divided into three general categories:
Chapter 2: Covered Call Writing 71
1. protective action to take if the stock drops,
2. aggressive action to take when the stock rises, or
3. action to avoid assignment if the time premium disappears from an in-the-money
call.
There may be times when one decides to close the entire position before expiration
or to let the stock be called away. These cases are discussed as well.
PROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE
The covered writer who does not take protective action in the face of a relatively sub
stantial drop in price by the underlying stock may be risking the possibility of large
losses. Since covered writing is a strategy with limited profit potential, one should
also take care to limit losses. Otherwise, one losing position can negate several win
ning positions. The simplest form of follow-up action in a decline is to merely close
out the position. This might be done if the stock declines by a certain percentage, or
if the stock falls below a technical support level. Unfortunately, this method of defen
sive action may prove to be an inferior one. The investor will often do better to con
tinue to sell more time value in the form of additional option premiums.
Follow-up action is generally taken by buying back the call that was originally
written and then writing another call, with a different striking price and/or expiration
date, in its place. Any adjustment of this sort is referred to as a rolling action. When
the underlying stock drops in price, one generally buys back the original call - pre
sumably at a profit since the underlying stock has declined - and then sells a call with
a lower striking price. This is known as rolling down, since the new option has a lower
striking price.
Example: The covered writing position described as "buy XYZ at 51, sell the XYZ
January 50 call at 6" would have a maximum profit potential at expiration of 5 points.
Downside protection is 6 points down to a stock price of 45 at expiration. These fig
ures do not include commissions, but for the purposes of an elementary example, the
commissions will be ignored.
If the stock begins to decline in price, taking perhaps two months to fall to 45,
the following option prices might exist:
XYZ common, 45;
XYZ January 50 call, l; and
XYZ January 45 call, 4.
72 Part II: Call Option Strategies
•
The covered writer of the January 50 would, at this time, have a small unrealized loss
of one point in his overall position: His loss on the common stock is 6 points, but he
has a 5-point gain in the January 50 call. (This demonstrates that prior to expiration,
a loss occurs at the "break-even" point.) If the stock should continue to fall from
these levels, he could have a larger loss at expiration. The call, selling for one point,
only affords one more point of downside protection. If a further stock price drop is
anticipated, additional downside protection can be obtained by rolling down. In this
example, if one were to buy back the January 50 call at 1 and sell the January 45 at
4, he would be rolling down. This would increase his protection by another three
points - the credit generated by buying the 50 call at 1 and selling the 45 call at 4.
Hence, his downside break-even point would be 42 after rolling down.
Moreover, if the stock were to remain unchanged - that is, if XYZ were exact


ample, if one were to buy back the January 50 call at 1 and sell the January 45 at
4, he would be rolling down. This would increase his protection by another three
points - the credit generated by buying the 50 call at 1 and selling the 45 call at 4.
Hence, his downside break-even point would be 42 after rolling down.
Moreover, if the stock were to remain unchanged - that is, if XYZ were exactly
45 at January expiration - the writer would make an additional $300. If he had not
rolled down, the most additional income that he could make, if XYZ remained
unchanged, would be the remaining $100 from the January 50 call. So rolling down
gives more downside protection against a further drop in stock price and may also
produce additional income if the stock price stabilizes.
In order to more exactly evaluate the overall effect that was obtained by rolling
down in this example, one can either compute a profit table (Table 2-21) or draw a
net profit graph (Figure 2-3) that compares the original covered write with the
rolled-down position.
Note that the rolled-down position has a smaller maximum profit potential than
the original position did. This is because, by rolling down to a January 45 call, the
writer limits his profits anywhere above 45 at expiration. He has committed himself
to sell stock 5 points lower than the original position, which utilized a January 50 call
and thus had limited profits above 50. Rolling down generally reduces the maximum
TABLE 2·21.
Profit table.
XYZ Price at Profit from Profit from
Expiration January 50 Write Rolled Position
40 -$500 -200
42 - 300 0
45 0 +300
48 + 300 +300
50 + 500 +300
60 + 500 +300
Chapter 2: Covered Call Writing
FIGURE 2-3.
Comparison: original covered write vs. rolled-down write.
+$500
c: +$300
0
~
]-
iii
en en
0 ...J
5
-e a.
$0
Original Write
Rolled-Down Write
50
Stock Price at Expiration
73
profit potential of the covered write. Limiting the maximum profit may be a second
ary consideration, however, when a stock is breaking downward. Additional downside
protection is often a more pressing criterion in that case.
Anywhere below 45 at expiration, the rolled-down position does $300 better
than the original position, because of the $300 credit generated from rolling down.
In fact, the rolled-down position will outperform the original position even if the
stock rallies back to, but not above, a price of 48. At 48 at expiration, the two posi
tions are equal, both producing a $300 profit. If the stock should reverse direction
and rally back above 48 by expiration, the writer would have been better off not to
have rolled down. All these facts are clear from Table 2-21 and Figure 2-3.
Consequently, the only case in which it does not pay to roll down is the one in
which the stock experiences a reversal - a rise in price after the initial drop. The
selection of where to roll down is important, because rolling down too early or at an
inappropriate price could limit the returns. Technical support levels of the stock are
often useful in selecting prices at which to roll down. If one rolls down after techni
cal support has been broken, the chances of being caught in a stock-price-reversal
situation would normally be reduced.
The above example is rather simplistic; in actual practice, more complicated sit
uations may arise, such as a sudden and fairly steep decline in price by the underly
ing stock. This may present the writer with what is called a locked-in loss. This means,
simply, that there is no option to which the writer can roll down that will provide him
74 Part II: Call Option Strategies
with enough premium to realize any profit if the stock were then called away at expi
ration. These situations arise more commonly on lower-priced stocks, where the
striking prices are relatively far apart in percentage terms. Out-of-the-money writes
are more susceptible to this problem than are in-the-money writes. Although it is not
emotionally satisfying to be in an investment position that cannot produce a profit -
at least for a limited period of time - it may still be beneficial to roll down to protect
as much of the stock price decline as possible.
Example: For the covered write described as "buy XYZ at 20, sell the January 20 call
at 2," the stock unexpectedly drops very quickly to 16, and the following prices exist:
XYZ common, 16;
XYZ January 20 call,½; and
XYZ January 15 call, 2½.
The covered writer is faced with a difficult choice. He currently has an unrealized
loss of 2½ points - a 4-point losson the stock which is partially offset by a 1 ½-point
gain on the January 20 call. This represents a fairly substantial percentage loss on his
investment in a short period of time. He could do nothing, hoping for the stock to
recover its loss. Unfortunately, this may prove to be wishful thinking.
If he considers rolling down, he will not be excited by what he sees. Suppose
that the writer wants to roll down from the January 20 to the January 15. He would
thus buy the January 20 at ½ and sell the January 15 at 2½, for a net credit of 2
points. By rolling down, he is obligating himself to sell his stock at 15, the striking
price of the January 15 call. Suppose XYZ were above 15 in January and were called
away. How would the writer do? He would lose 5 points on his stock, since he origi
nally bought it at 20 and is selling it at 15. This 5-point loss is substantially offset by
his option profits, which amount to 4 points: 1 ½ points of profit on the January 20,
sold at 2 and bought back at ½, plus the 2½ points received from the sale of the
January 15. However, his net result is a 1-point loss, since he lost 5 points on the stock
and made only 4 points on the options. Moreover, this 1-point loss is the best that he
can hope for! This is true because, as has been demonstrated several times, a covered
writing position makes its maximum profit anywhere above the striking price. Thus


, plus the 2½ points received from the sale of the
January 15. However, his net result is a 1-point loss, since he lost 5 points on the stock
and made only 4 points on the options. Moreover, this 1-point loss is the best that he
can hope for! This is true because, as has been demonstrated several times, a covered
writing position makes its maximum profit anywhere above the striking price. Thus,
by rolling down to the 15 strike, he has limited the position severely, to the extent of
"locking in a loss."
Even considering what has been shown about this loss, it is still correct for this
writer to roll down to the January 15. Once the stock has fallen to 16, there is noth
ing anybody can do about the unrealized losses. However, if the writer rolls down, he
can prevent the losses from accumulating at a faster rate. In fact, he will do better by
Chapter 2: Covered Call Writing 75
rolling down if the stock drops further, remains unchanged, or even rises slightly.
Table 2-22 and Figure 2-4 compare the original write with the rolled-down position.
It is clear from the figure that the rolled-down position is locked into a loss. However,
the rolled-down position still outperforms the original position unless the stock ral
lies back above 17 by expiration. Thus, if the stock continues to fall, if it remains
unchanged, or even if it rallies less than 1 point, the rolled-down position actually
outperforms the original write. It is for this reason that the writer is taking the most
logical action by rolling down, even though to do so locks in a loss.
TABLE 2-22.
Profits of original write and rolled position.
Stock Price at Profit from
Expiration January 20 Write
10 -$800
15 - 300
18 0
20 + 200
25 + 200
FIGURE 2-4.
Comparison: original write vs.
11
locked-in loss."
c: +$200 Original Write
~
t
«i
~
o -$100
~ a..
15 20
Stock Price at Expiration
Profit from
Rolled Position
-$600
- 100
- 100
- 100
- 100
76 Part II: Call Option Strategies
Technical analysis may be able to provide a little help for the writer faced with
the dilemma of rolling down to lock in a loss or else holding onto a position that has
no further downside protection. IfXYZ has broken a support level or important trend
line, it is added evidence for rolling down. In our example, it is difficult to imagine
the case in which a $20 stocksuddenly drops to become a $16 stock without sub
stantial harm to its technical picture. Nevertheless, if the charts should show that
there is support at 15½ or 16, it may be worth the writer's while to wait and see if
that support level can hold before rolling down.
Perhaps the best way to avoid having to lock in losses would be to establish posi
tions that are less likely to become such a problem. In-the-money covered writes on
higher-priced stocks that have a moderate amount of volatility will rarely force the
writer to lock in a loss by rolling down. Of course, any stock, should it fall far enough
and fast enough, could force the writer to lock in a loss if he has to roll down two or
thr..ee times in a fairly short time span. However, the higher-priced stock has striking
prices that are much closer together (in percentages); it thus presents the writer with
the opportunity to utilize a new option with a lower striking price much sooner in the
decline of the stock. Also, higher volatility should help in generating large enough
premiums that substantial portions of the stock's decline can be hedged by rolling
down. Conversely, low-priced stocks, especially nonvolatile ones, often present the
most severe problems for the covered writer when they decline in price.
A related point concerning order entry can be inserted here. When one simul
taneously buys one call and sells another, he is executing a spread. Spreads in gener
al are discussed at length later. However, the covered writer should be aware that
whenever he rolls his position, the order can be placed as a spread order. This will
normally help the writer to obtain a better price execution.
AN ALTERNATIVE METHOD OF ROLLING DOWN
There is another alternative that the covered writer can use to attempt to gain some
additional downside protection without necessarily having to lock in a loss. Basically,
the writer rolls down only part of his covered writing position.
Example: One thousand shares of XYZ were bought at 20 and 10 January 20 calls
were sold at 2 points each. As before, the stock falls to 16, with the following prices:
XYZ January 20 call, ½; and XYZ January 15 call, 2½. As was demonstrated in the last
section, if the writer were to roll all 10 calls down from the January 20 to the January
15, he would be locking in a loss. Although there may be some justification for this
action, the writer would naturally rather not have to place himself in such a position.
One can attempt to achieve some balance between added downside protection
and upward profit potential by rolling down only part of the calls. In this example,
Chapter 2: Covered Call Writing 77
the writer would buy back only 5 of the January 20's and sell 5 January 15 calls. He
would then have this position:
long 1,000 XYZ at 20;
short 5 XYZ January 20's at 2;
short 5 XYZ January 15's at 2½; and
realized gain, $750 from 5 January 20's.
This strategy is generally referred to a partial roll-down, in which only a portion of
the original calls is rolled, as opposed to the more conventional complete roll-down.
Analyzing the partially rolled position makes it clear that the writer no longer locks
in a loss.
IfXYZ rallies back above 20, the writer would, at expiration, sell 500 XYZ at 20
(breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000
from the five January 20's held until expiration, plus $1,250 from the five January 15's,
plus the $750 of realized gain from the January 20's that were rolled down. This
amounts to $3,000 worth of option profits and $2,500 worth of stock lo


ies back above 20, the writer would, at expiration, sell 500 XYZ at 20
(breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000
from the five January 20's held until expiration, plus $1,250 from the five January 15's,
plus the $750 of realized gain from the January 20's that were rolled down. This
amounts to $3,000 worth of option profits and $2,500 worth of stock losses, or an
overall net gain of $500, less commissions. Thus, the partial roll-down offers the
writer a chance to make some profit if the stock rebounds. Obviously, the partial roll
down will not provide as much downside protection as the complete roll-down does,
but it does give more protection than not rolling down at all. To see this, compare the
results given in Table 2-23 if XYZ is at 15 at expiration.
TABLE 2-23.
Stock at 15 at expiration.
Strategy
Original position
Partial roll-down
Complete roll-down
Stock Loss
-$5,000
- 5,000
- 5,000
Option
Profit Total Loss
+$2,000 -$3,000
+ 3,000 - 2,000
+ 4,000 - 1,000
In summary, the covered writer who would like to roll down, but who does not
want to lock in a loss or who feels the stock may rebound somewhat before expira
tion, should consider rolling down only part of his position. If the stock should con
tinue to drop, making it evident that there is little hope of a strong rebound back to
the original strike, the rest of the position can then be rolled down as well.
78 Part II: Call Option Strategies
UTILIZING DIFFERENT EXPIRATION SERIES WHEN ROLLING DOWN
In the examples thus far, the same expiration month has been used whenever rolling
down action was taken. In actual practice, the writer may often want to use a more
distant expiration month when rolling down and, in some cases, he may even want to
use a nearer expiration month.
The advantage of rolling down into a more distant expiration series is that more
actual points of protection are received. This is a common action to take when the
underlying stock has become somewhat worrisome on a technical or fundamental
basis. However, since rolling down reduces the maximum profit potential - a fact that
has been demonstrated several times - every roll-down should not be made to a more
distant expiration series. By utilizing a longer-term call when rolling down, one is
reducing his maximum profit potential for a longer period of time. Thus, the longer
term·call should be used only if the writer has grown concerned over the stock's capa
bility to hold current price levels. The partial roll-down strategy is particularly
amenable to rolling down to a longer-term call since, by rolling down only part of the
position, one has already left the door open for profits if the stock should rebound.
Therefore, he can feel free to avail himself of the maximum protection possible in the
part of his position that is rolled down.
The writer who must roll down to lock in a loss, possibly because of circum
stances beyond his control, such as a sudden fall in the price of the underlying stock,
may actually want to roll down to a near-term option. This allows him to make back
the available time premium in the short-term call in the least time possible.
Example: A writer buys XYZ at 19 and sells a 6-month call for 2 points. Shortly there
after, however, bad news appears concerning the common stock and XYZ falls quick
ly to 14. At that time, the following prices exist for the calls with the striking price 15:
XYZ common, 14:
near-term call, l;
middle-term call, 1 ½; and
far-term call, 2.
If the writer rolls down into any of these three calls, he will be locking in a loss.
Therefore, the best strategy may be to roll down into the near-term call, planning to
capture one point of time premium in 3 months. In this way, he will be beginning to
work himself out of the loss situation by availing himself of the most potential time
premium decay in the shortest period of time. When the near-term call expires
3 months from now, he can reassess the situation to decide if he wants to write
Chapter 2: Covered Call Writing 79
another near-term call to continue taking in short-term premiums, or perhaps write
a long-term call at that time.
When rolling down into the near-term call, one is attempting to return to a
potentially profitable situation in the shortest period of time. By writing short-term
calls one or two times, the writer will eventually be able to reduce his stock cost near
er to 15 in the shortest time period. Once his stock cost approaches 15, he can then
write a long-term call with striking price 15 and return again to a potentially prof
itable situation. He will no longer be locked into a loss.
ACTION TO TAKE IF THE STOCK RISES
A more pleasant situation for the covered writer to encounter is the one in which the
underlying stock rises in price after the covered writing position has been estab
lished. There are generally several choices available if this happens. The writer may
decide to do nothing and to let his stock be called away, thereby making the return
that he had hoped for when he established the position. On the other hand, if the
underlying stock rises fairly quickly and the written call comes to parity, the writer
may either close the position early or roll the call up. Each case is discussed.
Example: Someone establishes a covered writing position by buying a stock at 50 and
selling a 6-month call for 6 points. His maximum profit potential is 6 points anywhere
above 50 at expiration, and his downside break-even point is 44. Furthermore, sup
pose that the stock experiences a substantial rally and that it climbs to a price of 60
in a short period of time. With the stock at 60, the July 50 might be selling for 11
points and a July 60 might sell for as much as 7 points. Thus, the writer may consid
er buying back the call that was originally written and rolling up to the call with a
higher striking price. Table 2-24 summarizes the situation.


at the stock experiences a substantial rally and that it climbs to a price of 60
in a short period of time. With the stock at 60, the July 50 might be selling for 11
points and a July 60 might sell for as much as 7 points. Thus, the writer may consid
er buying back the call that was originally written and rolling up to the call with a
higher striking price. Table 2-24 summarizes the situation.
TABLE 2·24.
Comparison of original and current prices.
Original Position Current Prices
Buy XYZ at 50 XYZ common 60
Sell XYZ July 50 call at 6 XYZ July 50 11
XYZ Jul 60 7
If the writer were to roll-up - that is, buy back the July 50 and sell the July 60
- he would be increasing his profit potential. If XYZ were above 60 in July and were
called away, he would make his option credits - 6 points from the July 50 plus 7
80 Part II: Call Option Strategies
points from the July 60 - less the 11 points he paid to buy back the July 50. Thus, his
option profits would amount to 2 points, which, added to the stock profit of 10 points,
increases his maximum profit potential to 12 points anywhere above 60 at July expi
ration.
To increase his profit potential by such a large amount, the covered writer has
given up some of his downside protection. The downside break-even point is always
raised by the anwunt of the debit required to roll up. The debit required to roll up in
this example is 4 points - buy the July 50 at 11 and sell the July 60 at 7. Thus, the
break-even point is increased from the original 44 level to 48 after rolling up. There
is another method of calculating the new profit potential and break-even point. In
essence, the writer has raised his net stock cost to 55 by taking the realized 5-point
loss on the July 50 call. Hence, he is essentially in a covered write whereby he has
bought stock at 55 and has sold a July 60 call for 7. When expressed in this manner,
it may be easier to see that the break-even point is 48 and the maximum profit poten
tial, above 60, is 12 points.
Note that when one rolls up, there is a debit incurred. That is, the investor must
deposit additional cash into the covered writing position. This was not the case in
rolling down, because credits were generated. Debits are considered by many
investors to be a seriously negative aspect of rolling up, and they therefore prefer
never to roll up for debits. Although the debit required to roll up may not be a neg
ative aspect to every investor, it does translate directly into the fact that the break
even point is raised and the writer is subjecting himself to a potential loss if the stock
should pull back. It is often advantageous to roll to a more distant expiration when
rolling up. This will reduce the debit required.
The rolled-up position has a break-even point of 48. Thus, if XYZ falls back to
48, the writer who rolled up will be left with no profit. However, if he had not rolled
up, he would have made 4 points with XYZ at 48 at expiration in the original position.
A further comparison can be made between the original position and the rolled-up
position. The two are equal at July expiration at a stock price of 54; both have a prof
it of 6 points with XYZ at 54 at July expiration. Thus, although it may appear attrac
tive to roll up, one should determine the point at which the rolled-up position and
the original position will be equal at expiration. If the writer believes XYZ could be
subject to a 10% correction by expiration from 60 to 54 - certainly not out of the
question for any stock - he should stay with his original position.
Figure 2-5 compares the original position with the rolled-up position. Note that
the break-even point has moved up from 44 to 48; the maximum profit potential has
increased from 6 points to 12 points; and at expiration the two writes are equal, at 54.
In summary, it can be said that rolling up increases one's profit potential but also
exposes one to risk of loss if a stock price reversal should occur. Therefore, an ele-
Chapter 2: Covered Call Writing
FIGURE 2-5.
Comparison: original write vs. rolled-up position.
+$1,200
Rolled-Up Write
+$600 Original Write
54 60
Stock Price at Expiration
81
ment of risk is introduced as well as the possibility of increased rewards. Generally,
it is not advisable to roll up if at least a 10% correction in the stock price cannot be
withstood. One's initial goals for the covered write were set when the position was
established. If the stock advances and these goals are being met, the writer should be
very cautious about risking that profit.
A SERIOUS BUT ALL-TOO-COMMON MISTAKE
When an investor is overly intent on keeping his stock from being called away (per
haps he is writing calls against stock that he really has no intention of selling), then
he will normally roll up and/or forward to a more distant expiration month whenev
er the stock rises to the strike of the written call. Most of these rolls incur a debit. If
the stock is particularly strong, or if there is a strong bull market, these rolls for deb
its begin to weigh heavily on the psychology of the covered writer. Eventually, he
wears down emotionally and makes a mistake. He typically takes one of two roads:
(1) He buys back all of the calls for a (large) debit, leaving the entire stock holding
exposed to downside movements after it has risen dramatically in price and after he
82 Part II: Call Option Strategies
has amassed a fairly large series of debits from previous rolls; or (2) he begins to sell
some out-of-the-money naked puts to bring in credits to reduce the cost of continu
ally rolling the calls up for debits. This latter action is even worse, because the entire
position is now leveraged tremendously, and a sharp drop in the stock price may
cause horrendous losses - perhaps enough to wipe out the entire account. As fate
would have it, these mistakes are usually made when the stock is near a top in price.
Any price decline after such


o reduce the cost of continu
ally rolling the calls up for debits. This latter action is even worse, because the entire
position is now leveraged tremendously, and a sharp drop in the stock price may
cause horrendous losses - perhaps enough to wipe out the entire account. As fate
would have it, these mistakes are usually made when the stock is near a top in price.
Any price decline after such a dramatic rise is usually a sharp and painful one.
The best way to avoid this type of potentially serious mistake is to allow the
stock to be called away at some point. Then, using the funds that are released, either
establish a new position in another stock or perhaps even utilize another strategy for
a while. If that is not feasible, at least avoid making a radical change in strategy after
the stock has had a particularly strong rise. Leveraging the position through naked
put sales on top of rolling the calls up for debits should expressly be avoided.
The discussion to this point has been directed at rolling up before expiration. At
or near expiration, when the time value premium has disappeared from the written
call, one may have no choice but to write the next-higher striking price if he wants to
retain his stock. This is discussed when we analyze action to take at or near expiration.
If the underlying stock rises, one's choices are not necessarily limited to rolling
up or doing nothing. As the stock increases in price, the written call will lose its time
premium and may begin to trade near parity. The writer may decide to close the posi
tion himself - perhaps well in advance of expiration - by buying back the written call
and selling the stock out, hopefully near parity.
Example: A customer originally bought XYZ at 25 and sold the 6-month July 25 for
3 points - a net of 22. Now, three months later, XYZ has risen to 33 and the call is
trading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may
want to sell the stock at 33 and buy back the call at 8, thereby realizing an effective
net of 25 for the covered write, which is his maximum profit potential. This is cer
tainly preferable to remaining in the position for three more months with no more
profit potential available. The advantage of closing a parity covered write early is that
one is realizing the maximum return in a shorter period than anticipated. He is there
by increasing his annualized return on the position. Although it is generally to the
cash writer's advantage (margin writers read on) to take such action, there are a few
additional costs involved that he would not experience if he held the position until
the call expired. First, the commission for the option purchase (buy-back) is an addi
tional expense. Second, he will be selling his stock at a higher price than the striking
price, so he may pay a slightly higher commission on that trade as well. If there is a
dividend left until expiration, he will not be receiving that dividend if he closes the
Chapter 2: Covered Call Writing 83
write early. Of course, if the trade was done in a margin account, the writer will be
reducing the margin interest that he had planned to pay in the position, because the
debit will be erased earlier. In most cases, the increased commissions are very small
and the lost dividend is not significant compared to the increase in annualized return
that one can achieve by closing the position early. However, this is not always true,
and one should be aware of exactly what his costs are for closing the position early.
Obviously, getting out of a covered writing position can be as difficult as estab
lishing it. Therefore, one should place the order to close the position with his bro
kerage firm's option desk, to be executed as a "net" order. The same traders who facil
itate establishing covered writing positions at net prices will also facilitate getting out
of the positions. One would normally place the order by saying that he wanted to sell
his stock and buy the option "at parity" or, in the example, at "25 net." Just as it is
often necessary to be in contact with both the option and stock exchanges to estab
lish a position, so is it necessary to maintain the same contacts to renwve a position
at parity.
ACTION TO TAKE AT OR NEAR EXPIRATION
As expiration nears and the time value premium disappears from a written call, the
covered writer may often want to roll forward, that is, buy back the currently written
call and sell a longer-term call with the same striking price. For an in-the-money call,
the optimum time to roll forward is generally when the time value premium has com
pletely disappeared from the call. For an out-of-the-money call, the correct time to
move into the more distant option series is when the return offered by the near-term
option is less than the return offered by the longer-term call.
The in-the-money case is quite simple to analyze. As long as there is time pre
mium left in the call, there is little risk of assignment, and therefore the writer is
earning time premium by remaining with the original call. However, when the option
begins to trade at parity or a discount, there arises a significant probability of exer
cise by arbitrageurs. It is at this time that the writer should roll the in-the-money call
forward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1,
the writer should be rolling forward into the October 50 or January 50 call.
The out-of-the-money case is a little more difficult to handle, but a relatively
straightforward analysis can be applied to facilitate the writer's decision. One can
compute the return per day remaining in the written call and compare it to the net
return per day from the longer-term call. If the longer-term call has a higher return,
one should roll forward.
84 Part II: Call Option Strategies
Example: An investor previously entered a covered writing situation in which he
wrote five January 30 c


can be applied to facilitate the writer's decision. One can
compute the return per day remaining in the written call and compare it to the net
return per day from the longer-term call. If the longer-term call has a higher return,
one should roll forward.
84 Part II: Call Option Strategies
Example: An investor previously entered a covered writing situation in which he
wrote five January 30 calls against 500 XYZ common. The following prices exist cur
rently, l month before expiration:
XYZ common, 29¼;
January 30 call,¼; and
April 30 call, 2¼.
The writer can only make ¼ a point more of time premium on this covered write for
the time remaining until expiration. It is possible that his money could be put to bet
ter use by rolling forward to the April 30 call. Commissions for rolling forward must
be subtracted from the April 30's premium to present a true comparison.
By remaining in the January 30, the writer could make, at most, $250 for the 30
days remaining until January expiration. This is a return of $8.33 per day. The com
missions for rolling forward would be approximately $100, including both the buy
back and the new sale. Since the current time premium in the April 30 call is $250
per option, this would mean that the writer would stand to make 5 times $250 less
the $100 in commissions during the 120-day period until April expiration; $1,150
divided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April
30 than from the January 30, after commissions are included. The writer should roll
forward to the April 30 at this time.
Rolling forward, since it involves a positive cash flow ( that is, it is a credit trans
action) simultaneously increases the writer's maximum profit potential and lowers the
break-even point. In the example above, the credit for rolling forward is 2 points, so
the break-even point will be lowered by 2 points and the maximum profit potential
is also increased by the 2-point credit.
A simple calculator can provide one with the return-per-day calculation neces
sary to make the decision concerning rolling forward. The preceding analysis is only
directly applicable to rolling forward at the same striking price. Rolling-up or rolling
down decisions at expiration, since they involve different striking prices, cannot be
based solely on the differential returns in time premium values offered by the options
in question.
In the earlier discussion concerning rolling up, it was mentioned that at or near
expiration, one may have no choice but to write the next higher striking price if he
wants to retain his stock. This does not necessarily involve a debit transaction, how
ever. If the stock is volatile enough, one might even be able to roll up for even money
or a slight credit at expiration. Should this occur, it would be a desirable situation and
should always be taken advantage of.
Cbapter 2: Covered Ca# Writing
Example: The following prices exist at January expiration:
XYZ, 50;
XYZ January 45 call, 5; and
XYZ July 50 call, 7.
85
In this case, if one had originally written the January 45 call, he could now roll up to
the July 50 at expiration for a credit of 2 points. This action is quite prudent, since
the break-even point and the maximum profit potential are enhanced. The break
even point is lowered by the 2 points of credit received from rolling up. The maxi
mum profit potential is increased substantially - by 7 points - since the striking price
is raised by 5 points and an additional 2 points of credit are taken in from the roll up.
Consequently, whenever one can roll up for a credit, a situation that would normally
arise only on more volatile stocks, he should do so.
Another choice that may occur at or near expiration is that of rolling down. The
case may arise whereby one has allowed a written call to expire worthless with the
stock more than a small distance below the striking price. The writer is then faced
with the decision of either writing a small-premium out-of-the-money call or a larg
er-premium in-the-money call. Again, an example may prove to be useful.
Example: Just after the January 25 call has expired worthless,
XYZ is at 22,
XYZ July 25 call at ¾, and
XYZ July 20 call at 3½.
If the investor were now to write the July 25 call, he would be receiving only¾ of a
point of downside protection. However, his maximum profit potential would be quite
large if XYZ could rally to 25 by expiration. On the other hand, the July 20 at 3½ is
an attractive write that affords substantial downside protection, and its 1 ½ points of
time value premium are twice that offered by the July 25 call. In a purely analytic
sense, one should not base his decision on what his performance has been to date,
but that is a difficult axiom to apply in practice. If this investor owns XYZ at a high
er price, he will almost surely opt for the July 25 call. If, however, he owns XYZ at
approximately the same price, he will have no qualms about writing the July 20 call.
There is no absolute rule that can be applied to all such situations, but one is usual
ly better off writing the call that provides the best balance between return and down
side protection at all times. Only if one is bullish on the underlying stock should he
write the July 25 call.
86 Part II: Call Option Strategies
AVOIDING THE UNCOVERED POSITION
There is a margin rule that the covered writer must be aware of if he is considering
taking any sort of follow-up action on the day that the written call ceases trading. If
another call is sold on that day, even though the written call is obviously going to
expire worthless, the writer will be considered uncovered for margin purposes over
the weekend and will be obligated to put forth the collateral for an uncovered option.
This is usually not what the writer intends to do; being aware of this rule will elimi
nate unwanted margin calls. Furthermore, uncovered options may be considered
unsuitable for


n though the written call is obviously going to
expire worthless, the writer will be considered uncovered for margin purposes over
the weekend and will be obligated to put forth the collateral for an uncovered option.
This is usually not what the writer intends to do; being aware of this rule will elimi
nate unwanted margin calls. Furthermore, uncovered options may be considered
unsuitable for many covered writers.
Example: A customer owns XYZ and has January 20 calls outstanding on the last day
of trading of the January series (the third Friday of January; the calls actually do not
expire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the
January 20 call will almost certainly expire worthless. However, should the writer
decide to sell a longer-term call on that day without buying back the January 20, he
will be considered uncovered over the weekend. Thus, if one plans to wait for an
option to expire totally worthless before writing another call, he must wait until the
Monday after expiration before writing again, assuming that he wants to remain cov
ered. The writer should also realize that it is possible for some sort of news item to
be announced between the end of trading in an option series and the actual expira
tion of the series. Thus, call holders might exercise because they believe the stock will
jump sufficiently in price to make the exercise profitable. This has happened in the
past, two of the most notable cases being IBM in January 1975 and Carrier Corp. in
September 1978.
WHEN TO LET STOCK BE CALLED AWAY
Another alternative that is open to the writer as the written call approaches expira
tion is to let the stock be called away if it is above the striking price. In many cases,
it is to the advantage of the writer to keep rolling options forward for credits, there
by retaining his stock ownership. However, in certain cases, it may be advisable to
allow the stock to be called away. It should be emphasized that the writer often has
a definite choice in this matter, since he can generally tell when the call is about to
be exercised - when the time value premium disappears.
The reason that it is normally desirable to roll forward is that, over time, the
covered writer will realize a higher return by rolling instead of being called. The
option commissions for rolling forward every three or six months are smaller than the
commissions for buying and selling the underlying stock every three or six months,
and therefore the eventual return will be higher. However, if an inferior return has
Cl,opter 2: Covered Call Writing 87
to be accepted or the break-even point will be raised significantly by rolling forward,
one must consider the alternative of letting the stock be called away.
Example: A covered write is established by buying XYZ at 49 and selling an April 50
call for 3 points. The original break-even point was thus 46. Near expiration, suppose
XYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for
ward, now is the time to do so, because the call is at parity. However, he notes that
the choices are somewhat limited. Suppose the following prices exist with XYZ at 56:
XYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre
mium levels have declined since the original writing position was established, but
that is an occurrence beyond the control of the writer, who must work in the current
market environment.
If the writer attempts to roll forward to the October 50, he could make at most
1 additional point of profit until October (the time premium in the call). This repre
sents an extremely low rate of return, and the writer should reject this alternative
since there are surely better returns available in covered writes on other securities.
On the other hand, if the writer tries to roll up and forward, it will cost 4 points
to do so - 6 points to buy back the April 50 less 2 points received for the October 60.
This debit transaction means that his break-even point would move up from the orig
inal level of 46 to a new level of 50. If the common declines below 54, he would be
eating into profits already at hand, since the October 60 provides only 2 points of pro
tection from the current stock price of 56. If the writer is not confidently bullish on
the outlook for XYZ, he should not roll up and forward.
At this point, the writer has exhausted his alternatives for rolling. His remaining
choice is to let the stock be called away and to use the proceeds to establish a cov
ered write in a new stock, one that offers a more attractive rate of return with rea
sonable downside protection. This choice of allowing the stock to be called away is
generally the wisest strategy if both of the following criteria are met:
1. Rolling forward offers only a minimal return.
2. Rolling up and forward significantly raises the break-even point and leaves the
position relatively unprotected should the stock drop in price.
SPECIAL WRITING SITUATIONS
Our discussions have pertained directly to writing against common stock. However,
one may also write covered call options against convertible securities, warrants, or
LEAPS. In addition, a different type of covered writing strategy - the incremental
88 Part II: Call Option Strategies
return concept - is described that has great appeal to large stockholders, both indi
viduals and institutions.
COVERED WRITING AGAINST A CONVERTIBLE SECURITY
It may be more advantageous to buy a security that is convertible into common stock
than to buy the stock itself, for covered call writing purposes. Convertible bonds and
convertible preferred stocks are securities commonly used for this purpose. One
advantage of using the convertible security is that it often has a higher yield than does
the common stock itself.
Before describing the covered write, it may be beneficial to review the basics of
convertible securities. Suppose XYZ


to buy the stock itself, for covered call writing purposes. Convertible bonds and
convertible preferred stocks are securities commonly used for this purpose. One
advantage of using the convertible security is that it often has a higher yield than does
the common stock itself.
Before describing the covered write, it may be beneficial to review the basics of
convertible securities. Suppose XYZ common stock has an XYZ convertible Preferred
A stock that is convertible into 1.5 shares of common. The number of shares of com
mon that the convertible security converts into is an important piece of information
that the writer must know. It can be found in a Standard & Poor's Stock Guide (or
Bond Guide, in the case of convertible bonds).
The writer also needs to determine how many shares of the convertible securi
ty must be owned in order to equal 100 shares of the common stock. This is quickly
determined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since
100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd A to cover
the sale of one XYZ option for 100 shares of common. Note that neither the market
prices of XYZ common nor the convertible security are necessary for this computa
tion.
When using a convertible bond, the conversion information is usually stated in
a form such as, "converts into 50 shares at a price of 20." The price is irrelevant. What
is important is the number of shares that the bond converts into - 50 in this case.
Thus, if one were using these bonds for covered writing of one call, he would need
two (2,000) bonds to own the equivalent of 100 shares of stock.
Once one knows how much of the convertible security must be purchased, he
can use the actual prices of the securities, and their yields, to determine whether a
covered write against the common or the convertible is more attractive.
Example: The following information is known:
XYZ common, 50;
XYZ CV Pfd A, 80;
XYZ July 50 call, 5;
XYZ dividend, 1.00 per share annually; and
XYZ cv Pfd A dividend, 5.00 per share annually.
Chapter 2: Covered CaH Writing 89
Note that, in either case, the same call - the July 50 -would be written. The use of
the convertible as the underlying security does not alter the choice of which option to
use. To make the comparison of returns easier, commissions are ignored in the cal
culations given in Table 2-25. In reality, the commissions for the stock purchase,
either common or preferred, would be very similar. Thus, from a numerical point of
view, it appears to be more advantageous to write against the convertible than against
the common.
TABLE 2-25.
Comparison of common and convertible writes.
Write against Common Write against Convertible
Buy underlying security $5,000(100 XYZ) $5,360 (67 XYZ CV Pfd A)
Sell one July 50 call 500 - 500
Net cash investment $4,500 $4,860
Premium collected $ 500 $ 500
Dividends until July 50 250
Maximum profit potential $ 550 $ 750
Return (profit divided by
investment) 12.2% 15.4%
When writing against a convertible security, additional considerations should be
looked at. The first is the premium of the convertible security. In the example, with
XYZ selling at 50, the XYZ cv Pfd A has a true value of 1.5 times 50, or $75 per share.
However, it is selling at 80, which represents a premium of 5 points above its com
puted value of 75. Normally, one would not want to buy a convertible security if the
premium is too large. In this example, the premium appears quite reasonable. Any
convertible premium greater than 15% above computed value might be considered
to be too large.
Another consideration when writing against convertible securities is the han
dling of assignment. If the writer is assigned, he may either (1) convert his preferred
stock into common and deliver that, or (2) sell the preferred in the market and use
the proceeds to buy 100 shares of common stock in the market for delivery against
the assignment notice. The second choice is usually preferable if the convertible
security has any premium at all, since converting the preferred into common causes
the loss of any premium in the convertible, as well as the loss of accrued interest in
the case of a convertible bond.
90 Part II: Call Option Strategies
The writer should also be aware of whether or not the convertible is catlable
and, if so, what the exact terms are. Once the convertible has been called by the com
pany, it will no longer trade in relation to the underlying stock, but will instead trade
at the call price. Thus, if the stock should climb sharply, the writer could be incur
ring losses on his written option without any corresponding benefit from his con
vertible security. Consequently, if the convertible is called, the entire position should
normally be closed immediately by selling the convertible and buying the option
back.
Other aspects of covered writing, such as rolling down or forward, do not
change even if the option is written against a convertible security. One would take
action based on the relationship of the option price and the common stock price, as
usual.
WRITING AGAINST WARRANTS
It is also possible to write covered call options against warrants. Again, one must own
enough warrants to convert into 100 shares of the underlying stock; generally, this
would be 100 warrants. The transaction must be a cash transaction, the warrants
must be paid for in full, and they have no loan value. Technically, listed warrants may
be marginable, but many brokerage houses still require payment in full. There may
be an additional investment requirement. Warrants also have an exercise price. If the
exercise price of the warrant is higher than the striking price of the call, the covered
writer must also deposit the difference between the two as part of his investment.
The advantage of using warrants is that, if they are deeply in-the-money, they
may provide the cash covered writer with a higher r