Series 3: 4.3.1.2. Covered Call

4.3.1.2. Covered Call

Writing a call is an alternative means of hedging the price risk of a producer or investor who is long an asset or futures contract. A covered call is an options strategy in which an investor writes a call option against a product the investor already owns. A covered call is considered a partial hedge. While its main purpose is to increase income, it does reduce investor risk by the amount of the premium earned. Since the investor already owns the product, he cannot be put in the awkward position of having to find funds to buy the futures contract in the market, if the call is exercised.

If prices rise within a narrow range, the premium will absorb that loss. But the combined position is still vulnerable to a large rise in the market price of the underlying futures contract. If the price of the underlying rises and the call option is exercised, the farmer will need to sell the contract at the strike price even though he could have gotten a higher price. If one is confident that prices will remain relatively flat, a covered call can be a viable hedge. Assuming that a corn farmer writes a covered call with a strike price of 260’0 and a premium of 15’0, Table II below illustrates the type of protection a covered call will offer. As cash and futures prices increase, the net price he will receive peaks at $2.75, for a profit over the current spot market of 15 cents per bushel. As prices drop, the protection the covered call provides from any losses will never exceed 15 cents per bushel.