The term “covered call” and “conservative investment strategy” are typically seen going hand in hand.
However, for futures traders the relationship between the two can be immensely different.
When dealing with leveraged derivatives, such as futures contracts, as opposed to equities, the risks are elevated. In fact, a covered call strategy in such an arena can no longer be categorized as an investment. Instead, it is highly speculative trade. Nonetheless, when it comes to the high stakes and high reward world of commodity trading, a covered call or put strategy might provide traders with relatively attractive odds of success.
THE PURPOSE
The goal of a covered call or put strategy is to collect premium via the sale of options that stand to profit in the opposite direction of the asset price. The most traditional form is to buy one futures contract and sell one call option, or to sell one futures contract and sell one put option against it. With a one to one ratio between options and futures, the risk on the short option is “covered” by the futures contract.
Similarly, the risk of holding the futures position is “hedged,” or cushioned, by the premium collected through the sale of the option. Although we’ll focus on the traditional covered call, traders can provide an even larger buffer by selling two, or maybe even three, options to each futures contract held; but doing so requires they accept the opportunity cost of potentially having risk on both sides of the market. In either instance, selling options against a futures speculation works toward reducing the overall volatility of the trade.
WHY USE THEM?
Option selling, either outright, within a spread, or through a covered call or put strategy, has the potential to provide traders with an edge simply because options are eroding assets. Similar to driving a brand new car off the dealer’s lot and watching its value drop; all else being equal, options lose value with every minute that passes. Studies, including one conducted by the Chicago Mercantile Exchange, suggest that anywhere from 70% to 90% of options expire worthless. Accordingly, one could argue the likelihood of success side with the seller of the option, not the buyer.
This is not unlike the odds faced by casinos who know that there will be jackpots to pay, but in the long run theory suggests they will come out ahead. Of course, neither successful option selling, nor covered call writing, is as simple as blindly selling options and expecting 80% of your trades to be a success but playing on the right side of probability is certainly a step in the right direction.
The most compelling argument for some type of short option strategy in combination with futures position is that it automatically enables the trader some room for error. Although the strategy of buying or selling futures contracts is simple, such trades face immediate and uncompromising risk.
DISSECTING A COVERED CALL
By definition, a covered call is a strategy in which a trader that is long the underlying asset is also short a call option written against the same asset. Some call this approach a “buy-write” because it involves buying a futures contract and writing a call against it. In essence, the trader is taking a bullish stance in the futures market and a neutral to bearish stance in the option market.
Although this is considered an income strategy, traders implementing a covered call in a one to one ratio of futures to options is actually practicing a highly directional trade in which the income collected could be inconsequential should the direction of the trade prove to be inaccurate. In other words, the profit of a traditional covered call occurs if the underlying asset remains stable or increase but the risk of the market dropping is considerable. Depending on the strike price chosen, the premium collected for the short call option might only acts as a moderate buffer to futures market losses in a downturn.
Example:
Buy Crude Oil Futures @ $90.30
Sell $95.00 call option @ $2.30
A trader that goes long a crude oil futures contract at $90.30 and then sells a $95.00 call option has entered into a bullish strategy in which he has a buffer to be wrong in the amount of the premium collected. Simply put, at expiration this trader will be profitable as long as the futures price is higher than the entry of the futures contract minus $2.30, or $88.00. As Figure 1 portrays, at any point above $88 the trade is profitable but the risk below $88.00 (break-even point) is theoretically unlimited. The most the trader could make on a one by one covered call with these specifications is $7.00, which is equivalent to $7,000 in the full-sized crude oil future.
This is figured by accounting for the difference between the entry price of the futures contract and the strike price of the option, plus the premium collected. In other words, the trader makes money on the futures position from $90.30 up to $95.00; but because the short $95.00 call is antagonistic to the futures contract the gains are maxed out beyond this point. This is because above $95.00, for every penny the futures contract makes, the short call option loses. Don’t forget, the trader collected $2.30 (or $2,300) by selling the $95.00 and he gets to keep this, regardless of the outcome of the trade. Accordingly, the maximum profit of $7.00 ($7,000 in P&L) is calculated by subtracting $90.30 from $95.00 and adding $2.30.
GET CREATIVE
Options are an extremely versatile tool. Traders wishing to construct a covered call strategy can create a trade with nearly any desired risk and reward profile by carefully choosing strike prices and quantities. For example, conservative traders will look to collect more premium by selling close-to-the-money call options against a long futures contract, or they can sell two or three (rather than just one) out-of-the-money calls. There is no limit to the possibilities as long as you open your mind!
There is substantial risk of financial loss in trading options and futures. It is not suitable for everyone.
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