Covered call is a position in which you simultaneously buy the underlying stock and sell a call option against it. Its main purpose is to collect premium and have some cushion in case the underlying declines in value.
A typical example of a covered call is buying 100 shares of DOW, currently at $30.00, and selling against them 1 DOW April $32 Call, currently trading at .53 (or 1.75% of the underlying price). Against every hundred shares that you own, you can sell one call. The best case scenario is DOW closes a little bit above 32 and you keep the premium + you make $2. If it closes at let say 31.50, you still keep the premium, keep your shares and you make 1.50 from the move in the stock. Break-even of this covered call is at 29.43, because you are keeping the premium no matter what. Anything below 29.43 is a loss.
Under what circumstances is a good idea to initiate a covered call?
I believe it is a good strategy for people’s IRA. Let say you own a relatively low beta stock that pays a nice annual dividend. (stocks like PM, DOW, KO…). The stock is in your long-term core holdings. A covered call strategy will let you decrease your cost basis. Every month, you are going to sell 5% OTM Call options against your equity and collect a premium. Typically 5% OTM calls with 4 weeks to expiration are traded anywhere between 0.5% and 2% of the stock’s price, depending on volatility. For the purposes of the post, we’ll work with 1%. Every month, no matter what happens with the stock you will collect about 1% premium. If the stock doesn’t change its value, in the end of the year you will have 12% from selling premium + the dividend that the stock pays.
A downside of this strategy could be a missed opportunity if the underlying stock rises significantly above the strike of the sold OTM call. For example if in the next 6 weeks DOW goes up to 38, you will miss on the profit from 32 to 38, because you sold a $32 strike call. This is why, the covered call is an appropriate strategy for low beta stocks that pay nice sized dividends.
Recently some bank executives have used covered calls to get paid. They received bonuses in company’s shares, without being able to sell them in the next 2 years. Guess what? They still got paid by selling ATM and slightly OTM Calls expiring in 2 years against their stocks. Certainly the received premium is much less than the current stock price, but if you need your money now and can’t sell stocks, covered calls is one way to solve the problem.
If DOW is in your long-term holding, it means that you will be willing to add to your position on dips. An alternative to waiting for dips could be selling 5% OTM PUT options and collecting premium against it. In the case with DOW, currently trading at 30.00, you could sell April $28 PUTS for about .70 (or 2.3% of the stocks’ price). Typically 5% OTM puts with 4 weeks to expiration are traded for about .5% – 2% of the price of the underlying asset. You could sell 5% OTM PUTs every month and collect let say 1% premium. If the stock doesn’t experience tremendous volatility during the year, in the end you would have 12% gain only from selling premium via PUT options. If your stock drops to below the strike of your PUT, you will get exercised and you would have to buy shares at the strike at which each option was sold. For example, if DOW declines to 26 you will be exercised and you’ll have to buy it at $28, because you sold April $28 PUTs.
What will happen if you combine the two strategies and every month you sell 5% OTM Calls and 5% OTM Puts against your equity. Assuming your stock’s price starts and closes the year at approximately the same price, you have guaranteed minimum 24% income from premium + the dividend it pays. (broker’s commissions are not taken into account. The lower your capital and the more often you trade, the bigger the negative impact of commissions on your return).
