| Forex Options Part 7: Covered Calls |
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In the previous two sections we talked about the benefits of short options including having time decay on your side, higher probability outcomes and straddles for neutral or channeling markets. However, short options come with one disadvantage; if the market trends against your trade, a short option can lose value indefinitely. That disadvantage requires attention and can be managed, like any other risk in the market, but it is still something that traders need to think about.
Covered options are a strategy that can create consistent returns over the long term, but can also be managed more easily to limit downside risk than a short option. Covered options are an extremely popular strategy across the capital markets. If you have ever heard of a “covered call” in the stock market you have an idea what these are. It is a strategy that has been proven to improve returns by smoothing account volatility.
A covered option is a short option combined with a position in the spot forex. There are two versions of the strategy.
In this lesson we will walk through a covered call. In the next lesson of the Options Essentials course we will walk through a covered put. {mos_fb_discuss: 26}
To gain a better understanding of this strategy, let’s look at each component of a covered call.
When you enter into a covered call you are selling a call option, which is somewhat bearish. It is bearish because a call will lose value as the market drops. If you sold the call and then it drops in value, you profit because you can buy it back later for a lower price.
However, with a covered call, you are also long the underlying pair with a regular spot or futures position. That may sound contradictory, but in fact, it is a great position to be in. Because this trade has two contrary positions it is considered hedged.
Let’s look at an example to illustrate how this works and why it offers good profits with low volatility.
Anatomy of a Covered Call The chart below shows a few months worth of the AUD/USD in 2007. Let’s assume that on 12/21 (the third Friday of December) you decided to enter long the AUD/USD. You then turned it into a “covered call,” when you covered the position by selling a short call. You did that because the call will pay you a premium you can use to offset any losses if the market falls against your long position in the pair. A covered call is that simple.
Here’s how that works in detail:
Step one – Buy the pair: In the example above, let’s assume you bought the AUD/USD at 0.8671 on 12/21/2007 because you anticipated a rise in price.
Note: This is a great strategy for managing long term positions, because you may remain continuously long a particular pair for several months, and continue to sell new call options each month against that position.
Buying the pair removes (or “covers”) the unlimited risk we previously spoke of in the short call. If the market rises, the gains in the pair offset the losses of the short call. So now we sell the call.
Step two – Sell the call: Once we were long the pair, let’s assume we sell a call with a strike price that is 30-60 pips out of the money and 30 to 45 days out before expiration.
Selling the call to be a little out of the money gives your long pair position room to grow but still pays a nice premium. In the case study, you sold a call with a strike price of .8700 for $150. That call is the equivalent of a 10,000 lot. When trading covered calls you want to make sure you sell an equivalent number of calls to match your spot position.
Step three – Sit back and let the profits roll in! Of course, I am kidding (a little). There are two things that can happen at this point:
If the market rises (as it did in this case) In the example above, the market rose to .8788. This created a gain of 117 pips or $117 per mini lot on the long pair position.
Now, the short call lost value, but it still has some intrinsic value before expiration. You originally sold the call for $150 and at the point we are looking at on the spot price (.8788), the call still has $88 of intrinsic value. You buy back that call back, and you take $62 in profit.
The expiration value of the call is calculated by subtracting the strike price (.8700) from the spot price (.8788.) Here is a breakdown of the total profit on this position.
Gain on spot position = $117 (0.8788 - 0.8671) Gain on short call = $62 ($150 sell price - $88 expiration value) Total gain on position = $179
In this case, the trade paid more than an outright spot position over the same time frame would have. Obviously a great outcome. But you were also protected if the spot trade went against you.
If the market falls: Let’s assume that the AUD/USD had fallen to .8600 instead of rising. The short call would have served you well again, this time by offsetting all of the loss you would have had otherwise on the underlying spot position.
Loss on spot position = -$71 (0.8600 – 0.8671) Gain on short call = +$150 (call expired out of the money without value) Total gain on position = $79
As you can see, if the pair declines, the premium from the short call position will offset many or all of the losses from the spot position. In fact, in this example, the call will offset up to $150 of the potential losses in the long spot position.
One Disadvantage: Covered options can be great but they do have one disadvantage. If the market rises significantly, the short call losses may offset the gains from the long spot position. What this means is that a covered call has a maximum gain potential.
That maximum gain is equal to the premium you received for the option plus the distance between the initial spot price and the strike price. In the example on the AUD/USD, the maximum gain is $179 pips. Here is a good illustration to visualize how this works.
Imagine the pair shot up, and closed at 1.0000 even.
Gain on spot position = +$1,329 (1.0000 – 0.8671) Loss on short call = -$1,150 ($1,300 intrinsic value - $150 initial premium*) Total gain on position = +$179
*The intrinsic value at expiration is calculated as the difference between the spot price and the strike price of the option.
No matter what happens beyond that point, the loss on the call you sold will always be just $179 less than the gains on the spot position.
Conclusion: When you enter into a covered call, you are buying a hedge against losses if the market drops. You still retain upside potential, but you have given up the possibility of unlimited gains in return for that downside protection.
At first, that may sound a little strange, but because the market channels so frequently, over the long term, a covered call strategy will usually outperform an outright long position. It helps limit some of the losses you will inevitable encounter, smoothes volatility and makes your account management more efficient.
One very important note is that, like all strategies, this one can be managed as the market moves. Very frequently, as the market moves down and the call loses value, I will buy it back and resell another one closer to the current market price for another premium. That increases the amount of the hedge and amplifies long term gains. If you would like to see how that works in real time, check out our covered options strategy on the site. You can find that here.
Watch the video below, then proceed to the next lesson: Covered Puts
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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