Covered calls are a great, and in my opinion under used strategy from generating regular returns off open positions. “Capital preservation” is an old favorite among those people who want to use the stock market to grow their retirement savings to keep up with rising costs and some stable appreciation. They are some of the most risk averse investors in the stock market. The next step would be to be 100% into bonds. Using covered calls is a great strategy to write your own dividend, or use a methodical approach to lower your adjusted cost basis. Those two options are just how the individual decides to view the cash generated by writing covered calls, but the process is the same.
If you have your wealth in very safe stocks that appreciate exceptionally slowly, then writing covered calls can be a great way to skim some profit while you wait. Another bonus if you use a conservative dividend investment strategy is that you can write covered calls and still collect your dividends, and get an extra cash payment. It does not require all the exotic skills of options traders and is almost as easy as setting a limit order to sell at some predetermined price. You only need Level 1 options approval for covered calls, which is usually given with all accounts, there is no margin required because you are not borrowing anything. This method is also available in IRA accounts after filling out a simple form, or it is already included in your IRA depends on our broker.
A call is an agreement to sell the underlying security to the option holder for the strike price.
A covered call is writing an option contract on a stock that you own. For example if I own 100 shares of AAPL and then write 1 call, then I have written one call. Writing a call is the same as selling a call, but because you brought it into existence it is called writing. When you buy a stock you receive a “certificate” from the seller. When writing a covered call you basically write your own certificate. In your brokerage account this is called “sell to open” in the options order window. You write the option for a set strike price, which is the price the security has to cross to trigger it.
When you write a call you get a set amount of cash. When you see an option quote be aware that you have to multiply it by 100 in order get the actual value. Everything in options involves 100, because 1 option contract covers 100 shares. The cash payment you receive from writing a covered call is called “the premium.” The premium is the time value of your options determined by the amount of time till expiry and the implied volatility. Do not worry about implied volatility for now. Options also expire. It exists for the time period set out, and if it is not exercised by the option holder then it will expire. Whether it is exercised or not is determined by the price. Options nomenclature can get complicated. For that I apologize, but once you understand it covered calls are very simple.
An option writer sells to the option holder. An option is exercised by the holder, and assigned to the writer. Options now come in weeklies for select securities, these expire in one week. They usually appear Thursday and expire Friday of the next week. Monthly options are the most common and the one I recommend for covered call writing, these expire the third Friday of the month. You might here that options expire on Saturday but as a writer you do not have to worry about this since the market is closed and you know your status. Monthly options some time come 2 or 3 months in advance. Many stocks on the major exchanges have monthly options, and these are the standard when talking about options.
There are now quarterly options. These expire at the end of the quarter, i.e. March 31, June 30, September 30, and December 31. These are rarer. Then there are LEAPS (Long Term Equity AnticiPation Security). These are ones that expire in January for the year, and are usually available 2 years out. LEAPS are fairly common.
For the same security for the same strike price, the premium will be higher the longer it is till expiry. This is a general principle. It might not look that way on the quote pages but this is how it always works. Also if the price of the stock is unchanged, then every day that passes the option is worth less and less. The progression of the decline compounds the closer you get to expiry. Think of weekly options. The decline in value from Monday to Tuesday will be smaller than from Wednesday to Thursday if the price has not changed at all. Implied volatility is a complex measure that can determine the value of the premiums for the option. For the covered call strategy I will lay out, try not to worry too much about implied volatility unless you are curious. The conservative strategy for covered calls is to choose a strike, choose an expiry, be comfortable with the premium, write the option, and wait. That is it.
I know this is all complicated. Read it a few times if you have to. I will illustrate writing covered calls from beginning to end because examples are the best way to learn.
- Buy 100 shares of AAPL on January 1st @ $500 per share
- Write 1 February expiry monthly call option (which is for 100 shares) with a strike price of $550 @ $1.00 per share
- Collect a premium of $100 (100 shares * $1/share premium) minus commissions
- Wait till February expiry. Then one of two things can happen:
- AAPL is greater than $550, the call is assigned. You sell 100 shares of AAPL @ $550 per share. Your profit equals (100*$550) – (100*$500) + $100 premium – total commissions. Basically your profit is $50 dollars per share and your $100 premium minus commissions. In this case your only loss is opportunity cost. Let us say that AAPL reached $600. In that case you lost $50 per share of profit (no actual loss was suffered just the loss of 1/2 the profit). You sold that opportunity for $100. Now you might be thinking you got ripped off. Lost opportunity is the only risk to covered calls. Do not think of it like losing, think of it like winning less. Now lets say AAPL was at $550.10. You will get assigned this too. You will sell your 100 shares for $550. You lost 10 cents of profit per share, which is $10 total. However, you got $100 for the premium. Your profit on the premium is $90. You made more money by writing the option than if you held it. Those are the two types of assignment. You might make more money than you would by holding, or you might lose a bunch of profits. That is the price of being conservative. Still if you made $50 a share be happy. It stinks you didn’t make more, but let us see what happens at expiry to show you some of the benefits.
- This time lets say AAPL reaches only $530 at expiry. Well the option expires worthless. You keep the $100. You keep your shares. The holder loses their right to take your shares at $550. Now you can write a call again this time at $580 if you love AAPL for $1 per share again for $100 total. However, lets say you have $550 as your goal price for AAPL. You want to stick to it, well you can be rewarded for that too. At $530, writing a call at $550 two months out again might give you $2.00 a share depending on the market. This time you make $200, after keeping your $100. When an option expires you keep the premium, that is your reward. This is why I like covered calls.
My $1 premium was very low in that example. More likely it will be something like $10, sometimes the value of the option can amount to 10% of the stock price for highly volatile stocks, or it can be 10% because it is a very long dated option (remember value goes up as expiry moves further away). Highly volatile means that they move hard and fast. I am sure you’ve seen some stocks that move 0.5% a day, and some that swing 2% or 3% a day. The stocks that move faster command higher premiums.
Just think about what that means for the covered calls strategy. When you write a call that is 10% of the current price, then you have just taken 10% from your investment. If your strike price is at your buy price, you’re still up 10%. If I buy 100 shares of XYZ for $100 and then wrote calls with a strike of $100 for $10 a share, I would have 10% of my investment returned to me in cash. If I get assigned at $100, then I sell my shares at the price I bought them. No profit on the shares but I get to keep my 10% premium so I made 10%. This another benefit of covered calls. Consider the chance that the market slumps a bit, and now my stock is 99.50. Well now I keep my 10% and my shares. I’ll just turn around and write calls at a strike of $100 again. Hopefully, I can get $10 in premiums again, which is another 10% returned in cash.
You can look at that in two ways. Either you just earned a 10% dividend twice, or your lowered your cost. If I just took the dividends then I treat them like cash in my wallet. I can also mentally make a note that my adjusted cost fell. This is key if you’re looking to hold stocks for a while, but not forever. First time I write 10% premium calls I can subtract my cost basis by the amount per share. I bought at $100 per share and got $10 per share in premiums. My original cost basis is $100, well I got 10% of that investment back in cash, so now my adjusted cost basis is $90. Say I get 10% of my original cost basis the second time. I subtract $90 by $10 again, and my adjusted cost basis is $80. Now lets say the stock is hovering around $95. It is below my original cost basis, a $5 dollar loss, but I have my dividends. Using the adjusted cost basis method, I made $15 dollars a share. This is just two ways to look at the same situation. I personally use adjusted cost when the stock price falls below my original buy price. It lets me choose a profitable exit point, also lets me write my covered calls at a lower strike since I would still make a profit if assigned. However, if the stock goes up I treat it like a dividend and just subtract my sell price from my original price and add the dividends.
Choosing a strike is critical for covered calls. Choose a well paying strike above resistance. You can determine what well paying is for yourself, but if its too low just move back in time and write it there at the same strike above resistance. If it bounces off it is fine, you keep your premium and your stock. If it gets assigned, you sold for a profit and got your premiums. Do not worry about the lost profits. Enjoy the profits you made. You are choosing a conservative strategy for protection. You write calls to get cold hard cash while you wait for your stocks to move. Just choose a good strike.
In the example above, I used an out-of-the-money call (OTM call). This means the current price is lower than the strike price for a call. A more aggressive strategy for a stock you have held for a while with appreciation is to write in-the-money calls (ITM calls). In this case assume that I bought XYZ at $100 I wrote a bunch of calls through the months and years. Now XYZ is $175. I want to sell this security now. I decide to write a call with a strike at $150. This will be a large return. An OTM call has no intrinsic value, the value of the option is just the time value and the chance the strike price will be reached, hence it being called a premium it is a value over the intrinsic value. By definition OTM calls have $0 intrinsic value, all value is extrinsic. ITM calls have intrinsic value plus premium. In my example my call will have an intrinsic value of $25+the premium. The difference between the current price of $175 and my strike is $150. So I am locking in all of my gain over the strike and some extra premium. If the price drifts down, hence my reason for selling, to $160 I still have my $25 gain at $175 locked in with some premium. Covered calls provide some beautiful ways to exit a position.
The reason I brought up the complex issue of intrinsic and extrinsic value is that if you start writing covered calls I do not want you to get scared when your option goes from OTM to ITM. When you write an option it is like shorting a stock. If the value of the option goes up then you are in the red. For example, I write a call for XYZ at $100 for $10. The strike moves to $110. Now there is $10 of intrinsic value plus some premium. For convenience lets say it is now worth $20 a share (the total option is $2000). Well I wrote it at $10 or $1000. I have -1 call option. If I want to close my position (called a buy to close) and buy back the call I wrote I need to pay $2000 total, a loss of $1000. Do not get scared. You are not doing this on margin. It is not a naked call. You are covered. You won’t lose money if you let the option sit there. Your portfolio showing so much red is just showing you lost profits. This will eat into your account value, but when it expires and you are assigned you will simply sell the shares for $100, and take the value and keep your premium. Remember that red is offset by the appreciation of your underlying stock. In a perfect world these would be equal. They are equal when it comes to intrinsic value (intrinsic value tracks the difference between current price and strike price if its positive, if that number is negative it is 0). However, the premium can increase in value too. Lets say you got $1.00 per share in premium and it is not $1.10 per share. You are down $0.10 per share and your account value will be down that much, but it is not a real loss. If the option ends up expiring worthless your account value will bounce back. The negative is a place holder, but since you are covered you’ll be fine. The option will disappear and you won’t owe anything. It is only if you want to close your position that you’ll have to pay it. The opposite is true if the value of the option goes down. This is absolutely a placeholder. When an option expires worthless for the holder your gain on that option is 100%. So when you see your covered calls are up 50% that means you can lock in 50% of your premium right then and there, but you can get 100% if it expires worthless. This might just mean the underlying stock doesn’t move or continues its decline. Sometimes you’ll have lots of days to expiry, but the premiums will evaporate and you can lock in 90%+ right there (buy to close). In that case you might do it so you can write a more expensive call right there, but that is an addition to the covered calls strategy that is a bit too much for this already length article.
There are so many more strategies that I want to talk about, but this post is long enough. I will continue the series, but you now know all you need to know. There are some more active strategies you can employ, but those make it less conservative. I like the fire and forget covered calls strategy. Write and wait, if it doesn’t reach the strike rewrite.
After I discovered this strategy from various articles, I read a well written and informative book about it. I’ll review it at some point. For now just absorb the strategy and see if you can employ it.
Remember you are cutting off your upside for a new income stream. And this income stream can keep being used again and again until you have to sell your stock. It is like collecting interest from your stock position. You loaned money and get a return on the principal while you wait. Or its a dividend. Or it is rent. However you want to look at it, you are generating cash while you wait by giving up a potential opportunity. A bird in the hand is worth two in the bush, right?