How can we make additional income with Covered Calls? We first need to have some background. “Writing a covered call” is a two-step strategy that involves (1) holding a long position (a long position implies you own shares and you are reasonably confident that the shares will increase in price) in the underlying asset (e.g. a stock/share) and (2) selling (writing) a call option on the underlying asset. The strategy is usually employed by investors who believe that the underlying asset will experience only minor price fluctuations. A call option contract is established, and this requires you to hold a minimum 100 shares for each established contract.
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks (or shares). An options contract offers the buyer the opportunity to buy or sell – depending on the type of contract they hold – the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
Call options allow the holder to buy the asset at a stated price within a specific timeframe. An investor/trader would buy a Call option on the premise that they believe the underlying share will increase in value prior to expiry of that option contract.
Put options allow the holder to sell the asset at a stated price within a specific timeframe. An investor/trader would buy a Put option on the premise that they believe the underlying share will decrease in value prior to expiry of that option contract. Put options can used as a hedge against a portfolio of shares such that if the shares decrease in value, the Put option will increase in value and thus negate any losses on the portfolio.
Call options give the holder of the contract the right to buy the underlying share at a pre-specified price. At or before expiration, if the underlying asset rises above that strike price, the holder can exercise the option, obligating the seller of the option to deliver those shares at that price. If, however, the price fails to rise above the strike, the call holder can simply let his right expire without exercising it, and only lose the premium paid for the option.
When an investor is looking for an appropriate call option to write against, they will look at an option chain. An option chain, also known as an option matrix, is a listing of all available option contracts, both puts and calls, for a given security/stock. Each option chain will correspond to an option expiry date. Typically, we look out 4 weeks to expiry so as to maximise our option premium. Associated with each call option, will be the following information:
- Strike: This is the strike price that you would be obligated to sell the shares at if the option buyer chooses to exercise their option. This will occur if the price of the stock/share is greater than or equal to the strike price at the time of option expiry
- Price: This is the price that the option has been selling for recently. This is basically how much the option buyer pays the option seller for the option.
- Change: This shows you the recent changes in the option pricing.
- Bid: This is approximately what you will receive in option premiums per share up front if you sell the call. A market maker agrees to pay you this amount to buy the option from you.
- Ask: This is what an option buyer will pay the market maker to get that option from him/her. The difference between “bid” and “ask” is the market maker’s profit. The market maker is the ‘middle-man’ between option buyers and sellers that makes this a liquid market.
- Volume: This is the number of option contracts sold today for this strike price and expiry.
- Open Interest: This is the number of existing options for this strike price and expiration. It is the sum of all option volume leading up to today, minus any option positions that were closed prematurely.
Writing a Covered Call Example
Let us assume we own 300 shares of stock ‘XYZ’ and that the current price of ‘XYZ’ is $50.00
It is Friday 20 November 2020. We check the associated option chain, and we see a call option expiring on Friday 18 December 2020. For a strike price of $52.00, the associated bid price is $1.50 so this is the premium we will receive for each share after completing the contract. We have 300 shares, so we can write 3 contracts.
Our premium is $1.50 * 300 = $450 which we are paid immediately.
Below I will provide a summary of some possible outcomes. In order to keep things simple, I will exclude any brokerage costs which would need to be taken into consideration.
Possible outcomes after contract expiry:
- On expiry, 18 December 2020, the share price is $49.50. This is lower than the original price ($50.00) and lower than the strike price ($52.00). As such, the contract expires, and we keep our shares and option premium
- On expiry, 18 December 2020, the share price is $51.50. This is higher than the original price ($50.00) but still below the strike price ($52.00). As such, the contract expires, and we keep our shares and option premium
- On expiry, 18 December 2020, the share price is $53.00. This is higher than the original price ($50.00) and above the strike price ($52.00). As such, we are forced to sell our shares at $52.00 for a net profit of $2.00 per share = $600 and we also keep the original premium of $450.
- If we take into account the falling of the share price, after the contract closes we have a total of $450 – (300 * 0.50) = $300 which is a 1% return for the month (from our original total capital of $30,000) or 12% if annualized. We hold our original shares.
- If we take into account the rising of the share price, after the contract closes we have a total of $450 (premium) + $450 (rise in share price of $1.50 per share) which is a 3% return for the month (from our original total capital of $30,000) or 36% if annualized. We hold our original shares.
- If we take into account the rising of the share price, after the contract closes we have a total of $450 (premium) + $600 (rise in share price of $2 per share) which is a 3.5% return for the month (from our original total capital of $30,000) or 42% if annualized. In this case however, we are required to sell the shares.
What are the Potential Returns from Covered Calls?
Writing covered calls against Australian shares is likely to produce returns of approximately 1-2% per month (on average).
Against the US market where there are many more shares to choose from and a much more liquid trading environment, returns are more likely to be in the range 2-4% per month. Normally when there is high volatility in the market, % returns will increase but so will the risk of a more rapid rise/fall in the share price.
Also, generally one would not write calls for the following circumstances:
- During earnings reporting months as the price of the share will be volatile (In the US, reporting is 4 times per year and in Australia, it is 2 times per year)
- During the month where a dividend is paid (assuming the share you own has dividends paid). If you are holding the shares it is better to just recieve the dividend and then recommence covered call writing in the following month.
What are Covered Calls Pros and Cons?
As always, when considering a new investment strategy, there are specific strengths and weaknesses that investors need to consider before execution. The following is a summary of pros and cons associated with this strategy:
- Writing covered calls can allow you to earn additional income every month. By selling a covered call on shares that you are just holding in your portfolio you can generate an additional revenue stream above your dividends and share appreciation
- Covered call writing allows to profit from a share that is trending sideways. If your plan is to sell a share once it has risen a few dollars you can sometimes be frustrated when one of your holdings stays around the same price you originally paid for it. Covered calls can give you an extra cash flow while you are waiting for your share to rise in price
- Selling call options gives you a potential 12 times the earning power. A share that has options allows the owner to repeat the covered call strategy every month, all year long (perhaps aside from the couple of instances as previously outlined above)
- The premium you collect from selling the call option is yours to keep no matter what. Even if you are not called out at expiration, you can still hold on to the premium you received from opening the position
- An often-overlooked benefit to selling a covered call is that it can lower the cost of buying shares. Each time you receive premium effectively reduces the original price of the share.
- Selling call options against your shares automatically caps your profit potential should your share sharply rise in value. For example, if you sell a covered call at the $20 strike price you miss out on any profit if the stock closes above $20 on expiration. This is potentially the biggest drawback with the covered call strategy
- Opening a covered call positing does not protect you from having losses either. It does however help to protect your downside risk. Your breakeven point when writing a call is the amount of the call option you sold subtracted from the price you paid for each share
- Should the share price drop and you want to sell your position to prevent further losses, you would have to buy your call options back before you can sell any of the shares. Buying back the call options can also cause further losses to your portfolio.
Your PROFITABLE ACTION STEPS this time around:
- Continue to expand your knowledge regarding potential investment strategies. For more information on writing covered calls, refer to the book, “Complete Encyclopedia for Covered Call Writing”. Always seek advice from a qualified financial planner before making any significant investments.
- Check out my recent article on the Lazy Persons Guide to Investing
- If you haven’t already, go to my home page and download my Passive Income Guide. It describes a number of ways to earn income with minimal ongoing effort (in most cases) and it’s ABSOLUTELY FREE.
Stay safe, healthy and wise and most importantly of all, take ACTION.