Covered Calls – Fact and Fiction
Writing covered calls has been a staple in professional portfolio manager’s toolbox (including mine) for at least twenty years. It is frequently used and written about because its part of a sound investment strategy that never goes out of style. It’s also part of a tool-set that is often misunderstood, misused, and peddled like maps to the Lost Dutchman Goldmine.
We’re talking about option trading, not to be confused with investing. The loosening of regulatory authority allowing non-licensed individuals access to precious metals, currency, futures, binaries, options, and international equities markets has created a wild-wild west environment with hundreds of thousands of new market participants eagerly snapping up get rich quick schemes as fast as the shysters can dream them up.
The following information is for educational use only and should not be construed as investment advice or a solicitation for the marketing or sale of securities or advisory services.
I originally wrote this article several years ago. The data we used in our examples is a little dated, but the concepts work the same way now as they did then. Thank you.
Having thoroughly scared a lot of folks away from investing and options in the first two paragraphs, we can now address one of the best strategies around for serious investors who understand the fallacy of the get rich quick mentality.
A thorough discussion of all aspects of the equity options market is way beyond the scope of this article. My intention for now is to give you enough information and tools to get you started down the shortest path to understanding a time tested and proven strategy to reduce portfolio risk while enhancing your overall portfolio return.
Definition of an option contract: The link preceding this option definition goes into greater detail and offers a more complete picture. We will discuss only the call option as it relates to our covered call strategy. A covered call contract is an agreement between a seller who owns stock and a buyer who would like to acquire the same stock at a particular price (strike price), on or before a particular date (expiration date). A single call option contract gives the buyer/holder the right to buy 100 shares from the seller at the strike price, on or before the expiration date. The purchase price of the option contract paid by the buyer to the seller is called the premium. An option chain is a list of all open option positions for a particular security with strike price and expiration date.
The seller of the covered call option contract is not concerned about the short term movement of the stock price. He will write (sell) a contract at a strike price that is out of the money (higher than current market price) with an expiration date withing the next 30-180 days. The buyer of the call option believes the stock will be worth more than the strike price plus the premium before or on the expiration date.
However, if the price of the underlying stock rises substantially before the expiration date, the buyer may decide to exercise his option early, and the seller of the contract must sell his shares at the strike price. The seller may then buy the stock at the then current market price, or be patient and wait for a dip in price to repurchase the same stock. If however, the stock price does not rise to a level that is equal to or greater than the strike price plus the premium, the buyer will choose to let the contract expire worthless and the seller will keep the premium, write (sell) another contract, and begin the cycle again.
The seller of the call option is confident in the long-term prospects of the company he owns and is willing to hold during price declines. He tries to sell calls at market peaks and buy them back (close the position) at market troughs (sell high and buy back at a lower price) to maximize premium return. However, he is happy capturing premiums, dividends, and capital appreciation even if it means re-purchasing his stock at market when a contract is exercised.
About 70% of call contracts expire worthless. This strategy gives the investor an opportunity to generate premium income whether the stock price goes up or down although it caps the upside potential if the stock takes a fast run to the upside.
In our example the investor buys 500 shares of AAPL at $121.o6/share on November 6, 2015 for a total of $60,530. It has recently sold as high as $130/share. Analysts estimates for the one year price target average $148. The investor sells 5 contracts for the April 15, 2016 $130 strike at a premium of $4.45/share generating a total of $2,225 in premium income. The list below show the possible outcomes;
- By February 1, 2016 the stock price rises to $140. Buyer executes call option. Seller’s position is closed at the strike price of $130. The seller nets $70,000 on the sale of the stock + $2,225 for the option premium for a total short-term gain of $11,695 which will be taxed at his effective tax rate as ordinary income if this is a non-qualified account (not an IRA or ROTH). Advantages of ROTH accounts in another article.
- By February 1, 2016 the stock price drops to $110/share. Since the value of the call options he sold is now only worth about $.50, he decides to buy them back for $250 netting $1975 which will be taxed as ordinary income unless he has other trading losses to offset the gain. However, that frees up his underlying stock to write a November 2016 call for another premium. He has an unrealized loss on the shares, but he doesn’t care because he knows this is a high quality holding and he is not concerned with short term price movement except that it creates opportunities to write calls and earn premiums.
- The stock price never rises above $130 by the expiration date of April 15, 2015 and expires worthless. The buyer is disappointed. The seller nets $2,225, has an unrealized gain of $4,470 on his stock, writes another call for a later expiration date at least six months down the road, and collects another call premium.
The fundamental data shown below is from FinViz Elite, a tool I use to screen for and keep tabs on companies that make up my universe of portfolio worthy securities.
I use a screener called BornToSell to identify the best covered call opportunities with the smallest investment in time. Click on the link above or the ad below to get a free two week trial.
Characteristics and Risks of Standardized Options – Your broker (full service or discount) is required to provide this document and get a signed attestation from you saying you have read it before he can trade options for you or allow you to trade in your own account. At 188 pages, it covers way more than anybody cares to learn and its painful to read. This covered call tutorial will provide all the background you need to get started, then I’ll show you exactly how I put the strategy to work for my clients.
I mentioned earlier that covered call writing is part of a sound investment strategy. Other components of the strategy that I deploy for my clients include a well diversified portfolio of high quality dividend paying equities that includes stocks, real estate investment trusts, master limited partnerships, business development companies, and exchange traded funds. Characteristics that constitute “high-quality” vary from one asset class to another. All of these asset classes will be discussed in greater detail in other articles. I use FinViz Elite to look for securities that meet the criteria for inclusion in my portfolio universe.
Generally, a well diversified portfolio will have twenty to thirty securities from multiple market sectors at any given time without over-weighting any single market sector. All of the securities in the portfolio should have a market cap of at least two billion dollars and pay a sustainable and growing dividend. We call these dividend-growth companies. Long-term compounded dividend growth is a powerful portfolio builder but most market “enthusiasts” are blinded by the prospect of quick market gains of popular growth stocks that are in the news regularly.
Many securities with a two billion dollar market cap may not be option-able or have a substantial option chain. I include one or two megacap growth stocks (one hundred billion and above) with a big chain and three widely traded exchange traded funds (ETFs) that make up the core of the covered call strategy. Big CAP companies like Apple (AAPL), Facebook (FB), and Alphabet (GOOGL) are examples of optionable securities with substantial activity that might be a good fit for a covered call strategy.
Index based ETFs like SPDR Dow Jones Industrial Average ETF Trust (DIA), SPDR S&P 500 ETF Trust (SPY), and PowerShares QQQ Trust, Series 1 (QQQ) are examples of big CAP ETFs that are widely held and traded and have lots of options activity.
The basic idea is to buy and hold a diversified portfolio of 20-25 good quality dividend growth stocks and five or six big CAP holdings that will be the core of the covered call strategy. In every case, we buy only securities that we want to hold onto long-term regardless of short-term (3-6 month) price movements. Market prices are driven by emotion in the short term, but tend to move more fundamentals over the longer term. It is the short-term price swings that allow us to take advantage of the covered call trading strategy.
A free tool called Dividend Champions is maintained by David Fish and updated monthly. The tool is a great starting place to find potential securities to build your bullet proof income portfolio. It shows stocks with 25 years of annual increasing dividends.
All of the links mentioned in this article are tools that I use everyday to serve my clients. They are all available to the average investor at reasonable cost (free or less than $50/month). We will be offering live webinars on this subject at Insider Financial Workshops.