What Are Call Options?
Before we can discuss how to write covered calls, we need to first understand what a call option is. A single call option contract is an agreement that allows the buyer to purchase 100 shares by a specified expiration date at a certain strike price. These contracts can be both “purchased” and “written” depending on where one sees the company’s stock price going. The value of the contract will be based, in part, on the following:
How volatile the stock has been in the past
Anticipated or expected future price volatility
Amount of time until contract expiration
Types of Call Options
There are two types of call options: naked and covered. To understand covered calls, you need to first understand naked options.
1. Naked Call Options
In a naked call option, you write call options contracts without owning the underlying shares. While your bets might pay off, you could lose a lot of money too.
If you are writing naked call options, you think there is a chance a company’s stock price may fall. As the options writer, you have the flexibility to set the strike price and expiration date. If someone buys your options, he has purchased the right to acquire the stock from you at the predetermined strike price before the expiration date. This person has acquired your options since he believes the company’s stock price will rise before the expiration, and therefore wants to lock in a lower price. In effect, by writing a naked call option, you are betting that the company’s stock price will fall while the buyer is betting that the stock price will rise. It is simply two people speculating on share price direction.
The major risk involved with writing a naked call option is in the event that the stock rises in price. In this case, when the purchaser of the options exercises his options, you are forced to acquire the physical stock at the current price and sell these to the option holder at the predetermined lower price. You will be stuck with a loss, which sometimes can become crippling to your portfolio depending on how high the stock has risen.
How can one avoid this unlimited downside? By writing call options while also owning the underlying shares, known as a covered call, you can create numerous strategies that can net you significant income while limiting your potential losses.
2. Covered Call Options
In a covered call strategy, not only would you write call options, but you would also own the actual stock for which you are writing the options. Thus, if the stock price rises, while you would still be liable to provide the option holder with the physical shares, you can simply provide the option holder with the stock in your portfolio instead of being forced to buy the stock on the open market at the new, higher price. You have effectively eliminated the major risk that comes with a naked option.
Is the Covered Call Option Right for You?
Generally, a covered call strategy is ideal for someone who is bullish on a company’s stock price and therefore has acquired a substantial amount of shares, but also wants to create an additional income stream that will lower his net cost of shares and possibly protect him against a loss in share prices. By writing call options, the downside risk has been reduced, although the upside is also capped. Thus, if the stock price does indeed fall, the investor will lose money on his actual shares, but this will be offset by the income derived from selling call options (which presumably will not be exercised). Selling covered calls has the potential to be more profitable than simply holding shares if share prices fall, stay the same, or rise mildly. The only time that share investing will be more profitable than covered call trading is when there is a significant rise in share prices.
Covered Call Example
This is a simple example of how to employ the covered call strategy. You own 100 shares of Google (NASDAQ: GOOG). The share price is $550. You sell one 6-month long call option contract for $33.21 per share at a $550 strike price to protect you from a potential decrease in Google’s stock price.
At the end of those 6 months, the following may be true:
Share prices of Google are $550 or above. If the options are exercised, you must sell your shares for exactly $550 per share. You will have made a 6% return in 6 months from the $33.21 per share of income. Your break-even point is if Google is trading at $583.21 ($550 + $33.21 per share options premium); that is, you would have made the exact same amount of profit if you had simply held your shares and not written the call options. If Google is between $550 and $583.21, then you made a wise investment decision by writing the call options. If Google ends up higher than $583.21, you would have been better off not writing the options. Therefore, if you strongly feel that share prices will go higher than $583.21 in 6 months, you may want to simply hold the shares. But if you expect share prices to be neutral or have very mild gains, then selling call options is a great way to create income revenue as a replacement for the anticipated lack of capital gains.
Share prices are less than $550. In this case, the options will not be exercised and you will keep both your shares and the income from selling options. The $33.21 per share will help offset your share price loss. Your break-even point is if Google is trading at $516.79 ($550-$33.21). If Google trades above this point, you will have made a profit; if it trades below, you will have suffered a loss. Effectively, even one penny below this break-even point is where you would have been better off selling your 100 shares at $550 instead of holding them and writing the call options.
The big advantage for covered call writing as opposed to simple stock investing is an immediate 6% income payout regardless of how share prices perform. In this instance, the combination of options revenue plus share price movement means we are profitable even if stock prices fall up to 6%. The only time that holding shares is more advantageous than the covered call strategy is if share prices rise more than 6% in 6 months, which is certainly possible (but even in this case, you still will have made 6%).
Of course, the one other large downside is that we are forced to hold our shares until the options contract expires, or alternatively buy back the contract prior to expiration. This limiting factor should be taken into consideration as well.
Covered Call Strategies
Below are a few quick strategies you can use with covered calls. Some apply to blue chips stocks, others to high-risk companies, and some for those stocks for which you expect minimal gains.
1. Boosting Dividends
Buying shares and selling options contracts lowers your effective cost basis. In addition, you will still collect 100% of the dividends from companies who provide these payments. As a result, selling options contracts will increase your dividend yield. Below is an example:
You acquire Nutrisystem (NASDAQ: NTRI) shares, which provide quarterly dividends at $0.175 per share, at the current price of $14.24.
You then sell call options that expire in 9 months with a strike price of $10 per share that are valued at $4.50.
You receive an instant return of $4.50, which lowers your net cost per share to $9.74.
As explained above, share prices can fall almost 32%, from $14.24 to your net cost of $9.74, without any capital loss being incurred.
In addition, at your new cost basis of $9.74 per share, your annual dividend yield rises from 5% to 7.2%. Thus, while you have limited your capital gain upside, you have also significantly increased your dividend yield. This is an especially good strategy if you don’t think the underlying stock price will make large gains, or if you are very averse to risk and want to profit largely from dividends while creating a 32% hedge against falling share prices.
2. Adding Income Stream to Capital Gains
Another way to play covered calls is to set the strike price above the current price. You would do this if you expect share prices to appreciate moderately. By doing so, you profit from both a rise in share prices and the extra revenue from selling the options. Below is an example:
You anticipate that shares of Ford (NYSE: F), which currently trades at $15.28, will go up over the next 3 months.
You own shares at $15.28 each.
You sell a call options contract for $0.29 per share that will expire in 3 months with a strike price of $17 per share.
If share prices rise, you are allowed to keep the capital gains up to the $17 strike price, or $1.72 per share. In addition to this, you also receive 29 cents per share of income from selling the call options contract. It may not seem like much, but it has the ability to boost profits by 7.6% over the year (based on annualizing the 3 months call options contract price of 29 cents). Of course, your capital gains are also capped if share prices make a huge run beyond the $17 strike price.
3. Hedging Risk with Volatile Stocks
Risk goes way up when you hold shares in extremely volatile stocks. Buying call or put options for speculative trading can also be pricey since options derive much of their value from volatility. In such a case, you can buy the stock and sell call options that are “deep in the money” to protect against a significant decrease in stock price. “Deep in the money” refers to when the strike price is well below the current price. Thus, you have some protection against a downward fall, as well as a decent upside gain. Consider this example to see how it is carried out:
Solar stocks have high potential but a correspondingly high risk. One such stock, Energy Conversion Devices (NASDAQ: ENER), trades at $2.02 per share.
You acquire 100 shares at $2.02 per share.
You sell a call options contract with a $1.00 strike price for $1.27 per share and expires in 21 months.
Your effective cost basis per share is $0.75 per share.
Your maximum upside is $0.25 per share, or the difference between your net cost and the strike price.
How is this maximum upside calculated? Since your strike price is set at $1.00, you have essentially sold the rights on your stock above this amount. To put this another way, you will retain ownership up to $1.00, but if the price ends up above $1.00, the options will be exercised. Your potential reward is the difference between the $0.75 of net cost and the $1.00 of payment when the options are exercised at any amount above this. Thus, even if share prices fall to $1.00 (or a 50% drop from when you purchased it) and the rights are not exercised, you still made a 33% profit by turning 75 cents into one dollar. This is a great strategy when you’re invested in a stock that you believe has a high probability to suffer a significant decrease in price.
Writing call options on stock you own is a powerful and versatile investing tool that, when properly wielded, can boost dividends, create an extra income stream, and hedge against a downside risk. However, just because a stock is optionable and you are able to write covered calls on it, doesn’t necessarily mean that you should do so. Always analyse stocks on an individual basis, and assess whether you want to trade it based on business fundamentals, risk factors, and potential reward.
Source: Kurtis Hemmerling