Imagine having the ability to enter into an agreement with someone whereby that person is given the option (but not the obligation) to buy 100 shares of a stock from you at a defined price on or before a specific date. For the privilege of being guaranteed the option to buy this lot of shares from you at the price specified, that person would pay you a lump-sum of cash: if that person never exercises their option to purchase this lot of shares from you, there is no obligation to refund this upfront payment. This type of an agreement has a name: a call options contract. It is so named because the buyer of the contract has the option to call stock from the seller of the contract. The price paid by the buyer to the seller is named a premium, the price at which the shares are agreed to be sold is named the strike price, and the date by which the contract must be exercised is named the expiration date.
Suppose shares of stock were purchased on the open market and a call was sold at a strike price higher than the purchase price of these shares. In the event the share’s price never exceeds the strike price before the option expires, the purchaser will profit the premium paid and can sell another call. In the event the share price rises and the option is exercised, the purchaser will not only profit the premium paid for the call option, but also the capital gain from the sale of the stock. In this case, the purchaser can re-buy another lot of shares and sell a call on this new lot.
Case Study: [lec-stock-link]SYY[/lec-stock-link]
To demonstrate this principal, consider a lot of [lec-stock-link]SYY[/lec-stock-link] stock that contains 100 shares, and the writing of call options for its sale. The following is based on actual observations made.
February
The lot of 100 shares could have been purchased on February 1, 2022, for $79 per share. Then, a call could be sold to open for $15 such that the buyer of the contract would have the option to purchase this lot at $82 per share anytime in the next 3 days (on or before February 4). Another call expiring on February 11 could have been sold for $60 on February 7 with an $83 strike (the stock was trading at $79.68 at the time of sale). The process could have been repeated on February 15 for $40 with a strike of $85 (trading $83.79) expiring February 18. On February 21, a call could have been sold to open for $45 striking at $85 (price was $83.25) and expiring February 25; it is likely this contract would have been exercised. In February, $160 in premiums could have been collected incurring $2.68 in commissions for the privilege of writing the contracts for a net of $157.32.
March
With the final contract in February likely being exercised, a new lot could have been purchased on March 8, 2022, for $77 per share (note the repurchase price of the lot is less than or equal to the strike price of the exercised option contract). The process of writing call options could then be repeated; the first of which striking at $81 and expiring March 11, 2022, for $40. A second expiring March 18, 2022, and striking at $81 could have been sold for $15, and likely have been exercised. After re-buying the lot at $80 (again, note the repurchase price of the lot is less than or equal to the strike price of the exercised option contract), a call expiring on March 25, 2022, and striking at $83 could have been sold for $35. The final option sale of the month could have been sold for $40 with an expiration on April 1, 2022, at a strike of $84. In March, $130 could have been collected in premiums with $2.68 in commissions being paid. As an added bonus, $47 in dividends could have been earned; all totaling profit of $174.32.
Comparison
Over this 59-day period, price hit a high of $89.22 (on March 2) and a low of $74.80 (on February 8). If one purchased the stock at its low and sold at its high, a return of 19.278% could have been realized. During this same period, the covered-call strategy could have returned $284.64 in net premiums; an annualized return of 22.290%. If one incorporated the $47 in dividends received, $331.64 in cash could have been returned; an annualized return of 25.971%.