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What is "Covered Call Writing"?

Definition

The sale of calls on shares held in the portfolio of an investor is called covered call writing (CCW). (With one type of CCW, the shares for this strategy are bought first, and calls sold on the newly-acquired shares at the same time.)

Investors using covered call writing expect share price to remain constant. They hope to generate additional return for their portfolios in the form of option premiums.

Objective: Return enhancement
Expectation: Share prices remaining constant

Example

To enhance the return of an equity portfolio of 500 German XY shares, the investor sells 500 call options on the XY share with an exercise price of EUR 50 (out-of-the-money) at a price of EUR 2.50 per share. Current share price: EUR 46

As option contracts on German shares are usually based on 100 shares per contract at Eurex, the investor sells five contracts.

When the options expire there are several possible scenarios, depending on the share price prevailing at the time.

Share price upon expiration of the option Profit/loss on the shares Profit/loss on the calls Result share + calls
60 +14 -7.50 +6.50
55 +9 -2.50 +6.50
52,50 +6.50 0 +6.50
50 +4 +2.50 +6.50
46 0 +2.50 +2.50
44 -2 +2.50 +0.50
38 -8 +2.50 -5.50

Covered call writing is primarily a return-enhancing strategy used by investors expecting constant prices. When prices fall, the premium received acts as a risk cushion.

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Some investors also compare this strategy to a „sell limit order“, as the shares are sold at the exercise price plus the premium received when prices rise.

This strategy cannot be recommended if one is not able to sell the shares at all. In any case investors must take into consideration that when prices advance, options will be exercised at a price higher than their exercise price – and shares must be subsequently delivered

Caution: The option premium received acts only as a marginal cushion against falling prices. The option seller makes a loss with the shares in the portfolio, which is reduced only by the received premium. The form of CCW, where the shares are bought specially for the strategy, calls for particularly careful consideration. The options are not exercised when prices fall, and thus the shares remain in the investor's portfolio. Therefore the investor should basically be prepared to keep these shares.

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