Covered Calls on an S&P 500 Stock Portfolio?

May 8, 2002 12:00 PM, J. Kyle Graham

You may understand the covered call strategy on equities, but are you familiar with writing covered calls on a portfolio of S&P 500 stocks? How can you implement such a strategy? Stay tuned, this article will explain how.

Traditionally, the covered call strategy involves buying stock, the underlying, and simultaneously selling call options on a share-for-share basis. In this new variation, the underlying is a portfolio of stocks, rather than shares of a single stock. Also, the sold options are index calls. It is assumed that the underlying portfolio matches the performance of the index that is the underlying for the index calls. Specifically, if an investor owns a portfolio of S&P 500 stocks, then SPX Index calls can be written against this portfolio.

Before considering an example, review the specifications of the SPX index options presented in Table 1.

Underlying	The Standard & Poor's 500 Index is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares.
Multiplier	$100
Strike Price Intervals	Five points.
Expiration Date	Saturday immediately following the third Friday of the expiration month.
Expiration Months	Three near-term months followed by three additional months from the March quarterly cycle (March, June, September and December).
Exercise-settlement amount	This is equal to the difference between the exercise- settlement value, SET, and the exercise price of the option, multiplied by $100. Exercise will result in delivery of cash on the business day following expiration. Exercise style is European.

As an example, assume an investor owns a stock portfolio of S&P 500 stocks with a value of $112,500. Also assume that the level of the SPX Index is 1125. Since the multiplier is $100 (see Table 1), the underlying value of the 1125 Call is $112,500 (1125 x $100). If a 6-week 1125 Call (at-the-money) is sold for 21 points or $2,100 (21 x $100), then consider the profit potential and risk potential presented in Table 2 and on Graph 1.

SPX Value at Expiration	S&P 500 Portfolio	SPX 1125 6 Week Call	Profit and Loss at expiration
1150	+25	-4 (21 - 25)	21
1125	0	+21 (21 - 0)	21
1100	-25	+21 (21 - 0)	-4
1075	-50	+21 (21 - 0)	-29

First, note that the short market risk of the sold 1125 Call is offset by the owned (or long) stock portfolio. Second, consider the tradeoffs. Tradeoffs are simply the good and bad aspects of a strategy. No strategy is "better" in an absolute sense than another strategy; rather every strategy has advantages and disadvantages. In fact, every strategy is suitable for a given forecast. An accurate forecast remains a key factor and the first step in the selection of any strategy. Please note commissions and interest charges are not included in this example.

The advantage of the covered call is that income is generated in a neutral to moderately bullish market. Also, there is a limited amount of downside protection for the stock portfolio. In this example, protection is 21 points, and the breakeven point is an SPX Index level of 1104 (1125 - 21) at option expiration!

What, then is the disadvantage of covered calls? The difference between a long stock portfolio and this strategy is the profit potential. The covered call strategy has limited profit potential. In the example above, profit potential is capped at an index level of 1146 (1125 + 21). In contrast, the profit potential of an outright long portfolio is unlimited.

Above the 1125 SPX Strike Price: Above the 1125 level, the 1125 calls are likely to be assigned. Since the SPX is settled in cash the stock portfolio remains untouched. Early assignment is not possible since the SPX has a European Exercise Style.

Below the 1125 Strike: Below the 1125 level strike, you have the same risk as the portfolio ownership minus the premium received.

A variation of the traditional covered call strategy can implemented using a portfolio of S&P500 stocks and SPX Index options. First familiarize yourself with the contract specifications and with the mechanics of cash-settled options. Second, consider this strategy when you have a neutral to moderately bullish market forecast.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. CBOE and Chicago Board Options Exchange are registered trademarks of the Chicago Board Options Exchange, Incorporated. 2002 Chicago Board Options Exchange, Incorporated, All Rights Reserved.