Covered Options: An Alternative Investment Strategy

Abstract

* The creation of the Chicago Board Options Exchange (CBOE) in 1973 sparked an explosive enthusiasm for stock options. Since then, four additional exchanges have begun to trade stock options: the American, Philadelphia, Midwest, and Pacific Stock Exchanges. In May 1979, the Midwest Stock Exchange trading of options was consolidated with the CBOE. Expansion in both number of exchanges trading options and securities with options traded on them was halted by a moratorium on additions to the list of stocks by the Securities and Exchange Commission (SEC) in 1977. Since the moratorium was lifted in March 1980, expansion in options trading has been continuing. The investment opportunities open to investors with the creation of organized option exchanges are as varied as the combinations that can be created using common stock and call and put options. This study focuses on the selling of covered call options and its impact on portfolio return and risk. Selling of covered call options results in two advantages to the investor. First, there is a form of insurance against loss provided by the option premium. The investor can realize a loss on stock price equal to the option premium before an actual dollar loss occurs. Also, because the option premium received can be used as a credit toward the stock purchase, the investor's equity investment is reduced. This results in greater return on his equity when profits are realized. It appears that covered call options give the investor the best of both worlds: a hedge against losses if stock prices decline, and a higher return on equity if stock prices rise. Yet these benefits are not obtained without some cost: the