Selling Covered Calls...
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 your stock at a specified 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. Why? A rising market helps to maximize the yield (premium) of the held stock. Another advantage about covered calls investing is that the strategy helps to reduce cost in a declining market, too. Covered calls help 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.
- Buy a stock and sell a call option. The call is secured (covered) by the stock.
- This is a bullish to neutral strategy. You expect the stock price to stay the same or go up.
- A covered call is a conservative strategy used for generating current income and enhances dividends.
- The covered call strategy is one of the most popular option strategies used by 70% of our subscribers.
Call options should be written frequently, either monthly or weekly on the stocks you own. This is because the highest premiums are realized over shorter periods or time, rather than several months out in time. The stocks you choose for covered calls 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. Covered call investing is a bullish strategy, you want the stock price to go up. Therefore, companies that have rising sales and earnings are best suited for potential covered call candidates.
To keep commissions down, it's best to write calls for multiple contracts. Since each option contract represents 100 shares, consider writing calls for several hundred shares at a time. It is also desirable to have a least six or more diverse stocks in different industries, e.g. automotive and computer software.
In general, several rules of thumb to keep in mind: The highest returns come from writing calls that have a strike price that is near the stock price. Lower premium returns are obtained when the strike price of the call is higher than the stock price (in-the-money, ITM) or lower than the stock price (out-of-the-Money, OTM). And returns are higher for the short periods of time to expiration.
There are three underlying stock price movements that should be considered:
Constant stock price
Rising stock price
Falling stock price
1. Constant Stock Price (% if Unchanged)
A typical covered call investment might be:
|Name = Facebook Inc.
||Expiration = 5/20/16 (in 27 days)
|Symbol = FB
||Strike Price = $110
|Stock Buy Price = $109.00
||Call Sell Price = $5.20
|Stock Buy Date = 04/22/2016
||Option Sell Date = 04/22/2016
|# Shares = 100
||# Contracts = 1
You would receive a premium income of $520 ($5.20 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 = $520 ÷ [$10,900 - 520]
% If Not Assigned Return = 5.01 % (if the stock price stays at or below $110 on 05/20/2016)
Within each of PowerOptions Tools the return 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. Your cost is reduced by the premium. 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 assumption that the stock price remains unchanged over the period of the contract, you would continue to own your stock and it is not sold to the option buyer. You retain the premium and a new 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 Assigned)
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 = $11,000 - $10,900
Appreciation = $100.00
% if Assigned Return = [Premium Income + Appreciation] ÷ [Buy Value - Premium Income]
% if Assigned Return = [$520 + $100] ÷ [$10,900 - $520]
% if Assigned Return = 5.97 % (if your stock gets assigned at or over $110)
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 may be called (call option exercised or assigned) more often. When the stock price rises over the call strike price, it may be called, i.e. the stock is sold to a call buyer 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:
- Let the stock get called and repurchase each month, or
- Purchase the option back before it expires.
Deciding which approach is best (1 or 2 above) depends on several conditions. Two conditins to consider 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 (% Downside Protection)
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" (ITM), providing greater immediate income, while allowing more protection for falling stock prices and increasing the "% 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 strike price selected, 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 to increase the premium again.
For example: if an option is sold for $1.50 and in 2 weeks the option price 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.
We are often asked what to expect in terms of a yearly return form Covered Call investing. On average a 12% - 24% annual return or 1%- 2% per month is a reasonable expectation. Using leverage, margin, shorter periods of time, and more volatile stocks these returns can be increased, but with considerably more risk. The greatest risk in the covered call strategy comes from the possible decline of the underlying stock. If the market declines and your stock declines with the market, losses from a decline in your underlying stock price can just overwhelm any income gains from a covered call program.