The covered call strategy is straightforward. Monthly cash income is generated by selling call options against stock that you own. When selling a call option
you contract the delivery of stock owned at a price (strike price) for a specific amount of time (option month). In other words, the buyer has the right to buy your
stock (at the strike price), and you are paid a premium (price paid for the purchase right). This investment strategy works best in a rising market economy.
Why? It helps to maximize the yield (premium) of the held stock. What's safe about options investing is that the strategy works well in a declining market, too.
How? Use it to minimize losses by offsetting your stock's devaluation with premium income.
If you plan to hold the stock you buy or own for a long period of time, then writing covered calls (selling call options on owned stock) can greatly enhance the
yield performance of your stock portfolio.
Call options can be written monthly on the stocks you own. This is because the highest premiums are realized over single-month periods, rather than
two or more months out in time. The stocks you choose to hold or buy should be stocks you would not mind owning for a long period of time. They should be
steady growth stocks that have done well over the long term and can be prudently held even if a market decline occurs.
To keep commissions down, it's best to write calls in contracts (lots) of five to ten. Since each contract represents 100 shares, plan to hold 500 to
1000 shares of each stock. It is also desirable to have a least six or more diverse stocks in different industries, e.g. automotive and computer software.
In general, the stocks you wish to write a covered call on should be priced between $10 and $30 per share. This price range makes the yield higher.
Since the call premium (money received for sale of the option) does not go down as fast as the stock price, a higher yield is usually obtained with lower-priced stocks.
The table below illustrates this:
Call Strike Price
(One Month Out)
Yield on Premium
As shown when the strike price came down by a factor of 10 (from $100 to $10), the price of the option only decreased by 4 (from $2.50 to $.60).
The lower-priced stock will give a larger yield value. The example yield calculations above move from 2.5% to 6.0%, favoring lower price.
There are three price movement situations that should be examined:
Constant stock price
Rising stock price
Falling stock price
1. Constant Stock Price
A typical situation might be:
|Name = International Business Machines
||Expiration = 07/21/2001 - (July 95)
|Symbol = IBM
||Symbol = IBMGS
|Buy Price = $ 94.41
||Bid Price = $ 10.10
|Buy Date = 03/29/2001
||Sell Date = 03/29/2001
|# Shares = 100
||# Contracts = 1
You would receive a premium income of $1,010.00 ($10.10 X 100) for every 1 contract you sell.
Here is how you would calculate the return yield:
% If Not Assigned Return = Premium Income ÷ [Buy price of shares]
% If Not Assigned Return = $1,010.00 ÷ [$9,441.00]
% If Not Assigned Return = 10.7 % (if the stock price stays below $95 on 07/20/2001)
Within each of PowerOptions Tools the return, "% If Assigned", is calculated by subtracting the premium from the purchase price in the denominator. This treatment of return is
consistent with references like "Options for the Stock Investor", by James B. Bittman, pages 99-103. The return is increased slightly using this technique because the premium is immediately made available in your account, and can be re-invested. It should be noted that this yield is for the number of days until expiration of the option, to find the annualized yield multiply the yield by 365 divided by the number of days to expiration.
The calculation assumes margin borrowing was not used to purchase the stock. Assuming a 50% margin, twice as much stock can be purchased to generate twice the strategy yield. However, the use of margin increases the risk considerably in the event of a market down-turn. Covered call strategies can generate substantial income even when the stock price remains the same for a month, or an entire year.
Continuing with this scenario, assume the stock price remains the same over the period of the contract.
You continue to own your stock and it is not sold to the option holder. You retain the premium and a call can be written for the following month. Note: an option must be written each month to realize annualized returns.
2. Rising Stock Price
If the market is rising, you can choose a strike price that is slightly above the actual stock price. Accordingly, if the call option is exercised (assigned or called), your income will be the call premium on the option plus the appreciation of your stock valuation. This technique can enhance your return by several percent. If the stock price rose in the previous example the % If Assigned Return would have been:
Appreciation = Strike Value - Buy Value
Appreciation = $9,500 - $9,441
Appreciation = $59.00
% if Assigned Return = [Premium Income + Appreciation] ÷ [Buy Value - Premium Income]
% if Assigned Return = [$1,010.00 + $59.00] ÷ [$9,441.00 - $1,010.00]
% if Assigned Return = 12.7 % (if your stock gets assigned at $95 to cover the call write)
Also as the market rises, the stock generally moves in up/down cycles and not in a straight line. The stock price may rise for several days and then decline for several days. Stock purchases should be made on dips and the call selling should be done on a stock price rise. This methodology can enhance returns for all cases of stock movement.
During a rising market, the stock is called (call option exercised or assigned) more often. When it's called, the base stock is sold to the call holder to fulfill your contract. Subsequently, the stock must be repurchased with the proceeds to continue the cycle. There are two alternatives available to the investor:
1. Let the stock get called and repurchase each month, or
2. Purchase the option back before it expires.
Deciding which approach is best (1 or 2 above) depends on several conditions. Two examples include tax implications of the stock sale (long term gains) and the cost of commissions for stocks versus options. It generally pays to buy the option back.
3. Falling Stock Price
When the market is falling, select a strike price slightly below the actual price of the base stock. This circumstance is referred to as "in-the-money", providing greater income, "% If Assigned", while allowing for falling stock prices, "% Downside Protection".
If the stock falls rapidly, consider buying back the call option and selling another call at a lower strike price to increase the returns. This may be done several times in a month with the selected strike price following the stock price's downward movement.
During the call option interval, if the call option price erodes at a rate faster than expected, then buy back the call option. If 80% of the premium is gone it may pay to buy back the call option and write a call option at a lower strike price, or out an additional month.
For example: if an option is sold for $1.50 and in 2 weeks drops to $.25, buy it back and write another call for around $1.50, picking an option for the following month or picking a lower strike price. This makes it possible to collect the option premium several times during a month, providing cash income which helps to offset the unrealized stock loss.